**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC. 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

| **ý**                                                                                                                                                    | ** ** | **Quarterly report pursuant to Section 13  or 15(d) of the Securities Exchange Act of 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                    | ** ** | ** **                                                                                              |
| **for the quarterly period ended September 30,  2005**                                                                                                   |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                              |
| **or**                                                                                                                                                        |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                              |
| **o**                                                                                                                                                         | ** ** | **Transition report pursuant to Section 13  or 15(d) of the Securities Exchange Act of 1934** |
| ** **                                                                                                                                                    | ** ** | ** **                                                                                              |
| **for the transition period  from          to          ** |

 

**Commission File Number 000-24085**

 

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**AXT,INC.**

(Exact name of registrant asspecified in its charter)

 
| **DELAWARE**                                                    | ** ** | **94-3031310**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  Incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**4281 Technology Drive, Fremont, California94538**

(Address of principal executiveoffices) (Zip code)

 

**(510) 683-5900**

(Registrant’s telephone number,including area code)

 

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Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES  ý  NO  o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). YES  o NO  ý

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). YES  ý NO  o

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.

 
| **Class**                      | ** ** | **Outstanding  at October 28, 2005** |
|--------------------------------|------------|-------------------------------------------|
| Common Stock, $0.001 par value |       | 22,973,610                                |

 

 

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AXT, INC.FORM 10-QTABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION                                                                                            |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1. Financial Statements (unaudited)                                                                                      |   |
| Condensed Consolidated Balance Sheets as of  September 30, 2005 and December 31, 2004                               |   |
| Condensed  Consolidated Statements of Operations for the three and nine month periods  ended September 30, 2005 and 2004 |   |
| Condensed  Consolidated Statements of Cash Flows for the nine month periods ended September 30,  2005 and 2004           |   |
| Notes To  Condensed Consolidated Financial Statements                                                                         |   |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations                           |   |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                                           |   |
| Item 4.  Controls and Procedures                                                                                              |   |
| PART II. OTHER INFORMATION                                                                                               |   |
| Item 1. Legal Proceedings                                                                                                     |   |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                                          |   |
| Item 3.  Defaults Upon Senior Securities                                                                                      |   |
| Item 4.  Submission of Matters to a Vote of Security Holders                                                                  |   |
| Item 5. Other Information                                                                                                     |   |
| Item 6.  Exhibits                                                                                                             |   |
| Signatures                                                                                                                    |   |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

AXT, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(Unaudited, in thousands, except per share data)

 
| ** **                                                                                                                                                                                 | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Assets:                                                                                                                                                                                    |       |                         |       |                        |       |
| Current  assets                                                                                                                                                                            |       |                         |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                                 |       | $                            | 14,585     |                        | $          | 12,117 |   |
| Investments                                                                                                                                                                                |       | 9,655                        |       | 20,062                      |       |
| Accounts  receivable, net of allowance of $321 and $1,087 as of September 30, 2005  and December 31, 2004, respectively                                                          |       | 4,889                        |       | 4,034                       |       |
| Inventories,  net                                                                                                                                                                          |       | 15,600                       |       | 16,462                      |       |
| Prepaid  expenses and other current assets                                                                                                                                                 |       | 1,956                        |       | 2,523                       |       |
| Assets held  for sale                                                                                                                                                                      |       | —                       |       | 1,250                       |       |
| Total  current assets                                                                                                                                                                      |       | 46,685                       |       | 56,448                      |       |
| Property,  plant and equipment, net                                                                                                                                                        |       | 17,560                       |       | 19,045                      |       |
| Restricted  deposits                                                                                                                                                                       |       | 7,600                        |       | 8,215                       |       |
| Other assets                                                                                                                                                                               |       | 3,758                        |       | 3,832                       |       |
| Total assets                                                                                                                                                                               |       | $                            | 75,603     |                        | $          | 87,540 |   |
|                                                                                                                                                                                       |       |                         |       |                        |       |
| Liabilities  and stockholders’ equity:                                                                                                                                                |       |                         |       |                        |       |
| Current  liabilities                                                                                                                                                                       |       |                         |       |                        |       |
| Accounts  payable                                                                                                                                                                          |       | $                            | 2,316      |                        | $          | 1,895 |   |
| Accrued  liabilities                                                                                                                                                                       |       | 3,698                        |       | 4,765                       |       |
| Accrued  restructuring                                                                                                                                                                     |       | 375                          |       | 552                         |       |
| Current  portion of long-term debt                                                                                                                                                         |       | 450                          |       | 450                         |       |
| Income taxes  payable                                                                                                                                                                      |       | 3,056                        |       | 2,925                       |       |
| Total  current liabilities                                                                                                                                                                 |       | 9,895                        |       | 10,587                      |       |
| Long-term  debt, net of current portion                                                                                                                                                    |       | 7,150                        |       | 7,600                       |       |
| Other  long-term liabilities                                                                                                                                                               |       | 1,483                        |       | 1,336                       |       |
| Total  liabilities                                                                                                                                                                         |       | 18,528                       |       | 19,523                      |       |
| Commitments  and contingencies (Note 11)                                                                                                                                              |       |                         |       |                        |       |
| Stockholders’  equity:                                                                                                                                                                |       |                         |       |                        |       |
| Preferred  stock, $0.001 par value per share; 2,000 shares authorized; 883 shares issued  and outstanding                                                                                  |       | 3,532                        |       | 3,532                       |       |
| Common  stock, $0.001 par value per share; 70,000 shares authorized; 22,974 and  23,119 shares issued and outstanding at September 30, 2005 and December 31,  2004, respectively |       | 23                           |       | 23                          |       |
| Additional  paid-in capital                                                                                                                                                                |       | 155,247                      |       | 155,431                     |       |
| Accumulated  deficit                                                                                                                                                                       |       | (102,045                     | )          | (92,561                     | )          |
| Accumulated  other comprehensive income                                                                                                                                                    |       | 318                          |       | 1,592                       |       |
| Total  stockholders’ equity                                                                                                                                                           |       | 57,075                       |       | 68,017                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                                           |       | $                            | 75,603     |                        | $          | 87,540 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

3

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AXT, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited, in thousands, except per share data)

 
| ** **                                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Revenue                                                        |       | $                                          | 6,153      |                                      | $          | 8,531 |   | $ | 18,819 |   | $ | 27,831 |   |
| Cost of  revenue                                               |       | 5,008                                      |       | 10,767                                    |       | 17,268 |   | 28,705 |   |
| Gross profit  (loss)                                           |       | 1,145                                      |       | (2,236                                    | )          | 1,551 |   | (874 | ) |
| Operating  expenses:                                           |       |                                       |       |                                      |       |   |   |   |   |
| Selling,  general and administrative                           |       | 2,898                                      |       | 2,468                                     |       | 9,866 |   | 8,441 |   |
| Research and  development                                      |       | 472                                        |       | 397                                       |       | 1,257 |   | 1,088 |   |
| Asset  impairment charge                                       |       | —                                     |       | 210                                       |       | — |   | 210 |   |
| Restructuring  charges                                         |       | 14                                         |       | 158                                       |       | 376 |   | 1,235 |   |
| Total  operating expenses                                      |       | 3,384                                      |       | 3,233                                     |       | 11,499 |   | 10,974 |   |
| Loss from  operations                                          |       | (2,239                                     | )          | (5,469                                    | )          | (9,948 | ) | (11,848 | ) |
| Interest  income, net                                          |       | 136                                        |       | 95                                        |       | 386 |   | 173 |   |
| Other income  (expense), net                                   |       | (193                                       | )          | 225                                       |       | (494 | ) | 34 |   |
| Loss before  provision for income taxes                        |       | (2,296                                     | )          | (5,149                                    | )          | (10,056 | ) | (11,641 | ) |
| Provision  for incomes taxes                                   |       | 45                                         |       | 40                                        |       | 98 |   | 177 |   |
| Loss from  continuing operations                               |       | (2,341                                     | )          | (5,189                                    | )          | (10,154 | ) | (11,818 | ) |
| Discontinued  operations:                                      |       |                                       |       |                                      |       |   |   |   |   |
| Gain from  discontinued operations, net of tax                 |       | —                                     |       | —                                    |       | — |   | 222 |   |
| Gain from  disposal, net of tax                                |       | 259                                        |       | 225                                       |       | 670 |   | 225 |   |
| Net loss                                                       |       | $                                          | (2,082     | )                                         | $          | (4,964 | ) | $ | (9,484 | ) | $ | (11,371 | ) |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Basic and  diluted loss per share:                             |       |                                       |       |                                      |       |   |   |   |   |
| Loss from  continuing operations                               |       | $                                          | (0.10      | )                                         | $          | (0.22 | ) | $ | (0.45 | ) | $ | (0.52 | ) |
| Gain from  discontinued operations                             |       | 0.01                                       |       | 0.01                                      |       | 0.03 |   | 0.02 |   |
| Net loss                                                       |       | $                                          | (0.09      | )                                         | $          | (0.21 | ) | $ | (0.42 | ) | $ | (0.50 | ) |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Shares used  in computing basic and diluted net loss per share |       | 22,994                                     |       | 23,094                                    |       | 23,073 |   | 23,044 |   |
|                                                                |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to condensedconsolidated financial statements.

 

4

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AXT, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited, in thousands)

 
| ** **                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                               |       |                                      |       |   |   |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                             |       |                                      |       |   |   |
| Net loss                                                           |       | $                                         | (9,484     | ) | $ | (11,371 | ) |
| Adjustments  to reconcile net loss to net cash used in operations: |       |                                      |       |   |   |
| Depreciation                                                       |       | 2,874                                     |       | 3,647 |   |
| Amortization  of marketable securities premium/discount            |       | 188                                       |       | 207 |   |
| Non-cash  restructuring charge                                     |       | 376                                       |       | 1,235 |   |
| Asset  impairment charge                                           |       | —                                    |       | 210 |   |
| Loss on  disposal of property, plant and equipment                 |       | 291                                       |       | — |   |
| Stock based  compensation                                          |       | 2                                         |       | — |   |
| Gain on  disposal of discontinued operations                       |       | (53                                       | )          | — |   |
| Changes in  assets and liabilities:                                |       |                                      |       |   |   |
| Accounts  receivable, net                                          |       | (855                                      | )          | 1,060 |   |
| Inventories,  net                                                  |       | 862                                       |       | 6,078 |   |
| Prepaid  expenses                                                  |       | 567                                       |       | (1,000 | ) |
| Other assets                                                       |       | 74                                        |       | 30 |   |
| Accounts  payable                                                  |       | 421                                       |       | (478 | ) |
| Accrued  liabilities                                               |       | (1,620                                    | )          | (505 | ) |
| Income taxes                                                       |       | 131                                       |       | 203 |   |
| Other  long-term liabilities                                       |       | 147                                       |       | 58 |   |
| Net cash  used in operating activities                             |       | (6,079                                    | )          | (626 | ) |
|                                                               |       |                                      |       |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                             |       |                                      |       |   |   |
| Purchases of  property, plant and equipment                        |       | (1,711                                    | )          | (1,262 | ) |
| Proceeds  from sales of property, plant and equipment              |       | 31                                        |       | — |   |
| Purchases of  investments                                          |       | (7,783                                    | )          | (24,371 | ) |
| Proceeds  from sale of investments                                 |       | 16,958                                    |       | 13,222 |   |
| Proceeds  from sale of assets held for sale, net                   |       | 1,303                                     |       | — |   |
| Decrease in  restricted deposits                                   |       | 615                                       |       | 7,639 |   |
| Net cash  provided by (used in) investing activities               |       | 9,413                                     |       | (4,772 | ) |
|                                                               |       |                                      |       |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                             |       |                                      |       |   |   |
| Proceeds  from (payments of):                                      |       |                                      |       |   |   |
| Issuance of  common stock                                          |       | 60                                        |       | 270 |   |
| Repurchase  of common stock                                        |       | (246                                      | )          | — |   |
| Long-term  debt payments                                           |       | (450                                      | )          | (2,828 | ) |
| Net cash  used in financing activities                             |       | (636                                      | )          | (2,558 | ) |
| Effect of  exchange rate changes                                   |       | (230                                      | )          | (163 | ) |
| Net increase  (decrease) in cash and cash equivalents              |       | 2,468                                     |       | (8,119 | ) |
| Cash and  cash equivalents at the beginning of the period          |       | 12,117                                    |       | 24,339 |   |
| Cash and  cash equivalents at the end of the period                |       | $                                         | 14,585     |   | $ | 16,220 |   |
|                                                                    |            |                                           |            |  |  |  |  |  |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

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AXT, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)

 

**Note1. Basis of Presentation**

 

The accompanying condensed consolidated financial statements of AXT, Inc.(“AXT”, “Company”, “we,” “us,” and “our” refer to AXT, Inc. and all of itsconsolidated subsidiaries) are unaudited,and have been prepared in accordance with accounting principles generallyaccepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, certain information and footnote disclosurenormally included in financial statements prepared in accordance withaccounting principles generallyaccepted in the United States of America have been condensed or omitted.In the opinion of management, the unaudited condensed consolidated financialstatements reflect all adjustments, consisting only of normal recurringadjustments, considered necessary to present fairly the financial position, resultsof operations and cash flows of AXT and its subsidiaries for all periodspresented.

 

Management of the Company has made a number of estimates andassumptions relating to the reporting of assets and liabilities and thedisclosure of contingent assets and liabilities to prepare these condensedconsolidated financial statements in conformity with accounting principles generally accepted in the United States ofAmerica. Actual results could differ materially from those estimates.

 

The results of operations are not necessarily indicative of the resultsto be expected in the future or for the full fiscal year. It is recommendedthat these condensed consolidated financial statements be read in conjunctionwith our consolidated financial statements and the notes thereto included inour 2004 Annual Report on Form 10-K filed with the Securities and ExchangeCommission on March 18, 2005 and our Quarterly Reports on Form 10-Qfiled with the Securities and Exchange Commission on May 6, 2005, and August 9,2005, respectively.

 

Certain reclassifications have been made tothe prior years’ condensed consolidated financial statements to conform tocurrent period presentation.

 

**Note2. Discontinued Operations and related Assets Held for Sale**

** **

InJune 2003, we announced the discontinuation of our opto-electronicsdivision, which we had established as part of our May 1999 acquisition ofLyte Optronics, Inc.. The discontinued opto-electronics divisionmanufactured blue, cyan, and green high-brightness light emitting diodes (HBLEDs)for the illumination markets, including full-color displays, wireless handsetbacklighting and traffic signals, and also manufactured vertical cavity surfaceemitting lasers (VCSELs) and laser diodes for fiber optic communications andstorage area networks. Accordingly, the results of operations of theopto-electronics division have been segregated from continuing operations andare reported separately as discontinued operations in our condensedconsolidated statements of operations for all periods presented.

 

InSeptember 2003, we completed the sale of substantially all of the assetsof our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi(RMB) equivalent of $9.6 million. A portion of the purchase price equal to $1.0million was held in escrow to satisfy any claims that the purchasers might makefor breaches of representations or warranties by us. Of this total escrow,$750,000 could be released after the one year anniversary of the sale of theopto-electronics business and the remainder could be released after the secondanniversary of the sale. To date, we have resolved all claims made against the$1.0 million that was held in escrow. For the three month period ended September 30,2005, we recorded a gain for the final $250,000 that was held in escrow and$9,000 gain from interest. For the nine month period ended September 30,2005 we recorded $550,000 gains from escrow, $9,000 gain from interest, and$58,000 in property tax refunds.

 

InJune 2005, we completed the sale of a building located in Monterey Park,California. This asset had been classified as “assets held for sale” in theamount of $1.25 million on the condensed consolidated balance sheet as of December 31,2004. We received net proceeds on the sale of the property of approximately$1.3 million and accordingly recorded a gain on disposal of $53,000.

 

6

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Ourcondensed consolidated financial statements have been presented to reflect theopto-electronics business as a discontinued operation for all periodspresented. Operating results of the discontinued operation are as follows (inthousands):

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                              |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | — |   |
| Cost of revenue                      |       | —                                     |       | —                                    |       | — |   | — |   |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| Gross loss                           |       | —                                     |       | —                                    |       | — |   | — |   |
| Operating expenses:                  |       |                                       |       |                                      |       |   |   |   |   |
| Selling,  general and administrative |       | —                                     |       | —                                    |       | — |   | (222 | ) |
| Research and  development            |       | —                                     |       | —                                    |       | — |   | — |   |
| Impairment  costs                    |       | —                                     |       | —                                    |       | — |   | — |   |
| Total  operating expenses            |       | —                                     |       | —                                    |       | — |   | (222 | ) |
| Gain from operations                 |       | —                                     |       | —                                    |       | — |   | 222 |   |
| Gain from disposal                   |       | 259                                        |       | 225                                       |       | 670 |   | 225 |   |
| Net income                           |       | $                                          | 259        |                                      | $          | 225 |   | $ | 670 |   | $ | 447 |   |

 

The carrying value of the assets and liabilities of the discontinuedopto-electronics business included in the condensed consolidated balance sheetsare as follows (in thousands):

 
| ** **                       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Current assets:                  |       |                         |       |                        |       |
| Cash                             |       | $                            | 492        |                        | $          | 537 |   |
| Accounts  receivable, net        |       | 278                          |       | 19                          |       |
| Assets held  for sale            |       | —                       |       | 1,250                       |       |
| Total  current assets            |       | 770                          |       | 1,806                       |       |
| Other assets                     |       | —                       |       | 200                         |       |
| Total assets                     |       | $                            | 770        |                        | $          | 2,006 |   |
| Current liabilities:             |       |                         |       |                        |       |
| Accrued  liabilities             |       | $                            | 287        |                        | $          | 359 |   |
| Total liabilities                |       | 287                          |       | 359                         |       |
| Net assets                       |       | 483                          |       | 1,647                       |       |
| Total liabilities and net assets |       | $                            | 770        |                        | $          | 2,006 |   |

 

**Note****3. Accounting for Stock-Based Compensation**

 

Weaccount for stock-based employee compensation arrangements using the intrinsicvalue method as prescribed in Accounting Principles Board (“APB”) Opinion No. 25,*“Accounting for Stock Issued to Employees,”*and related interpretations thereof. Accordingly, compensation cost for stockoptions is measured as the excess, if any, of the market price of AXT’s stockat the date of grant over the stock option exercise price. The following tableillustrates the effect on our net loss and net loss per share if we had appliedthe fair value recognition provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123, *“Accountingfor Stock-Based Compensation,”* as amended by SFAS No. 148, *“Accounting for Stock-Based Compensation Transitionand Disclosure,”* to options granted under our stock option plans.For purposes of this pro forma disclosure, the value of the options isestimated using the Black-Scholes option pricing model and amortized to expenseover the options’ vesting periods. Because the estimated value is determined asof the date of grant, the actual value ultimately realized by the employee maybe significantly different.

 

 

7

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Had compensation cost for our options beendetermined based on the fair value at the grant dates, as prescribed in SFAS123 and SFAS 148, our pro forma net loss and net loss per share would have beenas summarized below (in thousands (except per share data):

 
| ** **                                                                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss available  to common stockholders:                                                    |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                                                    |       | $                                          | (2,126     | )                                         | $          | (5,008 | ) | $ | (9,616 | ) | $ | (11,503 | ) |
| Less:  Stock-based employee compensation expense included in net loss as reported              |       | 5                                          |       | —                                    |       | 2 |   | — |   |
| Less:  Stock-based compensation expense using the fair value based method, net of  related tax |       | (206                                       | )          | (244                                      | )          | (673 | ) | (1,090 | ) |
| Pro forma  net loss                                                                            |       | $                                          | (2,327     | )                                         | $          | (5,252 | ) | $ | (10,287 | ) | $ | (12,593 | ) |
| Basic and  diluted net loss per share:                                                         |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                                                    |       | $                                          | (0.09      | )                                         | $          | (0.22 | ) | $ | (0.42 | ) | $ | (0.50 | ) |
| Pro forma                                                                                      |       | $                                          | (0.10      | )                                         | $          | (0.23 | ) | $ | (0.45 | ) | $ | (0.55 | ) |
|                                                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Shares used  in computing basic and diluted net loss per share                                 |       | 22,994                                     |       | 23,094                                    |       | 23,073 |   | 23,044 |   |

 

We calculated the fair value of each optiongrant on the date of grant using the Black-Scholes option pricing model asprescribed by SFAS 123 using the following assumptions:

 
| ** **                               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Weighted average risk free interest rate |       | 4.18                                      | %          | 2.00 | % |
| Expected life (in years)                 |       | 5.0                                       |       | 5.0 |   |
| Dividend yield                           |       | —                                    |       | — |   |
| Volatility                               |       | 92.45                                     | %          | 70.50 | % |

 

Theweighted average grant date fair value of options granted during the nine monthperiod ended September 30, 2005 and 2004 were $0.89 and $1.20 per share,respectively.

 

Ananalysis of historical information is used to determine the above assumptions,to the extent that historical information is relevant, based on the terms ofthe grants being issued in any given period. Assumptions related to theEmployee Stock Purchase Plan are not presented as the related compensationexpense amounts are insignificant.

 

Weare currently evaluating the impact of adopting Statement of FinancialAccounting Standards No. 123 (revised 2004) (“SFAS 123R”) on our financialposition and results of operations beginning January 1, 2006.

 

8

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**Note4. Cash, Cash Equivalents and Investments**

** **

Ourcash, cash equivalents and investments are classified as follows (inthousands):

 
| ** **                                   | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **Amortized  Cost**              | ** ** | **Gross  Unrealized  Gain**     | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gain** | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** |
| **Classified as:**                           |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash                                         |       | $                                | 6,954      |                            | $          | — |   | $ | — |   | $ | 6,954 |   | $ | 8,638 |   | $ | — |   | $ | — |   | $ | 8,638 |   |
| Cash equivalents:                            |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Money market fund                            |       | 1,413                            |       | —                          |       | — |   | 1,413 |   | 1,681 |   | — |   | — |   | 1,681 |   |
| US Treasury and agency securities       |       | —                           |       | —                          |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Commercial paper                             |       | 6,218                            |       | —                          |       | — |   | 6,218 |   | 398 |   | — |   | — |   | 398 |   |
| Repurchase agreements                        |       | —                           |       | —                          |       | — |   | — |   | 1,400 |   | — |   | — |   | 1,400 |   |
|                                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total cash equivalents                       |       | 7,631                            |       | —                          |       | — |   | 7,631 |   | 3,479 |   | — |   | — |   | 3,479 |   |
| Total cash and cash equivalents              |       | 14,585                           |       | —                          |       | — |   | 14,585 |   | 12,117 |   | — |   | — |   | 12,117 |   |
|                                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                                 |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| US Treasury and agency securities            |       | 5,145                            |       | —                          |       | (11 | ) | 5,134 |   | 10,468 |   | — |   | (16 | ) | 10,452 |   |
| Asset-backed securities                      |       | 3,223                            |       | —                          |       | (16 | ) | 3,207 |   | 4,410 |   | — |   | (25 | ) | 4,385 |   |
| Commercial paper                             |       | 498                              |       | —                          |       | — |   | 498 |   | 1,708 |   | — |   | (1 | ) | 1,707 |   |
| Corporate bonds                              |       | 6,477                            |       | —                          |       | (19 | ) | 6,458 |   | 8,737 |   | — |   | (30 | ) | 8,707 |   |
| Corporate equity securities                  |       | 1,467                            |       | 491                             |       | — |   | 1,958 |   | 1,465 |   | 1,561 |   | — |   | 3,026 |   |
| Total investments                            |       | 16,810                           |       | 491                             |       | (46 | ) | 17,255 |   | 26,788 |   | 1,561 |   | (72 | ) | 28,277 |   |
| Total cash, cash equivalents and investments |       | $                                | 31,395     |                            | $          | 491 |   | $ | (46 | ) | $ | 31,840 |   | $ | 38,905 |   | $ | 1,561 |   | $ | (72 | ) | $ | 40,394 |   |
|                                         |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Contractual maturities on investments:**   |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Due within 1 year                            |       | $                                | 14,389     |                            |       |   |   |   | $ | 14,848 |   | $ | 21,879 |   |   |   |   |   | $ | 23,394 |   |
| Due after 1 through 5 years                  |       | 2,421                            |       |                            |       |   |   | 2,407 |   | 4,909 |   |   |   |   |   | 4,883 |   |
|                                         |       | $                                | 16,810     |                            |       |   |   |   | $ | 17,255 |   | $ | 26,788 |   |   |   |   |   | $ | 28,277 |   |

 

The investments include $7.6 million and $8.2million recorded as restricted deposits on the condensed consolidated balancesheets as of September 30, 2005 and December 31, 2004, respectively.

 

Wemanage our investments as a single portfolio of highly marketable securitiesthat is intended to be available to meet our current cash requirements. As of September 30,2005 and December 31, 2004, we had no gross realized gains or losses onsales of our available-for-sale securities.

 

Thegross unrealized losses related to our portfolio of available-for-salesecurities were primarily due to a decrease in the fair value of debt andequity securities as a result of an increase in interest rates during 2004 andthe first nine months of 2005. We have determined that the gross unrealizedlosses on our available-for-sale securities as of September 30, 2005 aretemporary in nature. We reviewed our investment portfolio to identify andevaluate investments that have 

 

9

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indicationsof possible impairment. Factors considered in determining whether a loss istemporary include the magnitude of the decline in market value, the length oftime the market value has been below cost (or adjusted cost), credit quality,and our ability and intent to hold the securities for a period of timesufficient to allow for any anticipated recovery in market value. The followingtable provides a breakdown of our available-for-sale securities with unrealizedlosses as of September 30, 2005 (in thousands):

 
| ** **                         | ** ** | **In Loss Position  < 12 months** | ** ** | **In Loss Position  > 12 months** | ** ** | **Total In  Loss Position** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **Fair  Value**                                          | ** ** | **Gross  Unrealized  (Loss)**                            | ** ** | **Fair  Value**                  | ** ** | **Gross  Unrealized  (Loss)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Loss)** | ** ** |
| ** **                         | ** ** | ** **                                               | ** ** | ** **                                               | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Short-term investments:            |       |                                                     |       |                                                     |       |                             |       |   |   |   |   |   |   |
| US Treasury  and agency securities |       | $                                                        | 5,134      |                                                     | $          | (11                              | )          | $ | — |   | $ | — |   | $ | 5,134 |   | $ | (11 | ) |
| Asset-backed  securities           |       | 1,644                                                    |       | (7                                                       | )          | 1,563                            |       | (9 | ) | 3,207 |   | (16 | ) |
| Commercial  paper                  |       | 498                                                      |       | —                                                   |       | —                           |       | — |   | 498 |   | — |   |
| Corporate  bonds                   |       | 5,614                                                    |       | (16                                                      | )          | 844                              |       | (3 | ) | 6,458 |   | (19 | ) |
| Total in  loss position            |       | $                                                        | 12,890     |                                                     | $          | (34                              | )          | $ | 2,407 |   | $ | (12 | ) | $ | 15,297 |   | $ | (46 | ) |

 

**Note5. Inventories, Net**

 

The components of inventories are summarized below (in thousands):

 
| ** **        | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------|------------|------------------------------|------------|-----------------------------|------------|
| Inventories, net: |       |                         |       |                        |       |
| Raw  materials    |       | $                            | 5,528      |                        | $          | 4,416 |   |
| Work in  process  |       | 9,324                        |       | 10,474                      |       |
| Finished  goods   |       | 748                          |       | 1,572                       |       |
|              |       | $                            | 15,600     |                        | $          | 16,462 |   |

 

**Note6. Restructuring Charges**

 

Our restructuring accrual is as follows (in thousands):

 
| **For the three month period ended September 30, 2005** | ** ** | **Restructuring Accrual  as of June 30, 2005**     | ** ** | **Additions/  Reversals** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of  September 30, 2005** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------|------------|--------------|------------|-----------------------------------------------------------|------------|
| Future lease  payments related to abandoned facilities       |       | $                                                       | 487        |                      | $          | 5            |       | $                                                         | (117       | ) | $ | 375 |   |
| Workforce  reduction                                         |       | —                                                  |       | —                    |       | —       |       | —                                                    |       |
| Japan office  closure                                        |       | 17                                                      |       | 9                         |       | (26          | )          | —                                                    |       |
| Total                                                        |       | $                                                       | 504        |                      | $          | 14           |       | $                                                         | (143       | ) | $ | 375 |   |
|                                                         |       |                                                    |       |                      |       |         |       |                                                      |       |
| **For the nine month period ended September 30, 2005**  | ** ** | **Restructuring Accrual  as of December 31, 2004** | ** ** | **Additions/  Reversals** | ** ** | **Payments** | ** ** | **Restructuring  Accrual as of  September 30, 2005** | ** ** |
| Future lease  payments related to abandoned facilities       |       | $                                                       | 552        |                      | $          | 213          |       | $                                                         | (390       | ) | $ | 375 |   |
| Workforce  reduction                                         |       | —                                                  |       | 56                        |       | (56          | )          | —                                                    |       |
| Japan office  closure                                        |       | —                                                  |       | 107                       |       | (107         | )          | —                                                    |       |
| Total                                                        |       | $                                                       | 552        |                      | $          | 376          |       | $                                                         | (553       | ) | $ | 375 |   |

 

10

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On March 14, 2005, we announced that we wouldbe reducing the workforce at our Beijing, China manufacturing facility byapproximately 100 positions or approximately 15%. This measure was taken aspart of our ongoing effort to reduce our cost structure and bring capacity inline with current market demand. We recorded a restructuring charge of $56,000in the nine month period ended September 30, 2005 relating to the reductionin work force, which we completed in June 2005. On an annual basis, weanticipate payroll and related expense savings of approximately $0.3 millionrelating to this reduction in force.

 

On April 28, 2005, we closed our Japan officeas part of our ongoing effort to reduce our cost structure. For the three and nine month periods ended September 30,2005 we recorded restructuring charges of $9,000 and $107,000,respectively, relating to the closureof our Japan office. On an annual basis, we anticipate payroll and relatedexpense savings of approximately $0.3 million relating to the closure of ourJapan office.

 

For the three and nine month periods ended September 30,2005, we recorded restructuring charges of $5,000 and $213,000,respectively, relating to leasecosts associated with facilities located in California that are no longerrequired to support production. The remaining restructuring accrual for futurelease payments related to abandoned U.S. facilities of $375,000 is expected tobe paid out through 2006, and is included on the accompanying condensedconsolidated balance sheet as accrued restructuring.

 

**Note 7. Net Loss Per Share**

 

Basic net loss per common share iscalculated by dividing net loss available to common stockholders by theweighted average number of common shares outstanding during the period. Dilutednet loss per common and common equivalent shares include the dilutive effect ofcommon stock equivalents outstanding during the period calculated using thetreasury stock method. Common stock equivalents consist of the shares issueableupon the exercise of stock options.

 

A reconciliation of the numerators and denominators of the basic anddiluted net loss per share calculations is as follows (in thousands, except per share data):

 
| ** **                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                                         |       | $                                          | (2,082     | )                                         | $          | (4,964 | ) | $ | (9,484 | ) | $ | (11,371 | ) |
| Less:  Preferred stock dividends                                                 |       | (44                                        | )          | (44                                       | )          | (132 | ) | (132 | ) |
| Net loss  available to common stockholders                                       |       | $                                          | (2,126     | )                                         | $          | (5,008 | ) | $ | (9,616 | ) | $ | (11,503 | ) |
| Denominator:                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Denominator  for basic net loss per share - weighted average common shares       |       | 22,994                                     |       | 23,094                                    |       | 23,073 |   | 23,044 |   |
| Effect of  dilutive securities:                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Common stock  options                                                            |       | —                                     |       | —                                    |       | — |   | — |   |
| Denominator for dilutive net loss per  common share                              |       | 22,994                                     |       | 23,094                                    |       | 23,073 |   | 23,044 |   |
| Basic and diluted net loss per share                                             |       | (0.09                                      | )          | (0.22                                     | )          | (0.42 | ) | (0.50 | ) |
| Options  excluded from diluted net loss per share as the impact is anti-dilutive |       | 2,956                                      |       | 2,365                                     |       | 2,956 |   | 2,365 |   |
|                                                                                  |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

**Note8. Comprehensive Loss**

 

The components of comprehensive loss are as follows (in thousands):

 
| ** **                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                  |       | $                                          | (2,082     | )                                         | $          | (4,964 | ) | $ | (9,484 | ) | $ | (11,371 | ) |
| Foreign currency translation loss                         |       | (12                                        | )          | (107                                      | )          | (230 | ) | (164 | ) |
| Unrealized gain (loss) on available for  sale investments |       | 377                                        |       | (786                                      | )          | (1,044 | ) | (2,238 | ) |
| Comprehensive loss                                        |       | $                                          | (1,717     | )                                         | $          | (5,857 | ) | $ | (10,758 | ) | $ | (13,773 | ) |
|                                                           |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

11

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**Note9. Segment Information and Foreign Operations**

 

***Segment Information***

*** ***

Weoperate in one segment for the design, development, manufacture anddistribution of high-performance compound semiconductor substrates and sale ofmaterials. In accordance with SFAS No. 131, *“Disclosures about Segments of an Enterprise andRelated Information,”* (“SFAS No. 131”) our chief operatingdecision-maker has been identified as the Chief Executive Officer, who reviewsoperating results to make decisions about allocating resources and assessingperformance for the Company. All material operating units qualify foraggregation under SFAS No. 131 due to their identical customer baseand similarities in economic characteristics, nature of products and services,and procurement, manufacturing and distribution processes. Since we operate inone segment, all financial segment and product line information required bySFAS No. 131 can be found in the condensed consolidated financialstatements.

 

***GeographicalInformation***

*** ***

Thefollowing table represents revenue amounts (in thousands) reported for productsshipped to customers in the corresponding geographic region:

 
| ** **      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net revenues:   |       |                                       |       |                                      |       |   |   |   |   |
| North  America* |       | $                                          | 1,481      |                                      | $          | 1,873 |   | $ | 3,684 |   | $ | 6,161 |   |
| Europe          |       | 1,328                                      |       | 1,731                                     |       | 4,911 |   | 5,433 |   |
| Japan           |       | 1,087                                      |       | 1,274                                     |       | 1,887 |   | 3,533 |   |
| Taiwan          |       | 704                                        |       | 1,940                                     |       | 2,840 |   | 7,623 |   |
| Asia Pacific    |       | 1,553                                      |       | 1,713                                     |       | 5,497 |   | 5,081 |   |
| Consolidated    |       | $                                          | 6,153      |                                      | $          | 8,531 |   | $ | 18,819 |   | $ | 27,831 |   |

 

----

*                    Primarilythe United States

 

12

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Long-livedassets consist primarily of property, plant and equipment, and are attributedto the geographic location in which they are located. Long-lived assets bygeographic region were as follows (in thousands):

 
| ** **         | ** ** | **As of**               | ** ** |
|--------------------|------------|------------------------------|------------|
| ** **         | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
| Long-lived assets: |       |                         |       |   |   |
| North  America     |       | $                            | 6,582      |   | $ | 7,163 |   |
| Asia Pacific       |       | 10,978                       |       | 11,882 |   |
|               |       | $                            | 17,560     |   | $ | 19,045 |   |

 

***Significant Customers***

*** ***

Twocustomers represented 10.9% and 10.3%, respectively, of revenues for the threemonth period ended September 30, 2005. Two customers represented 11.5% and10.7%, respectively, of revenues for the three month period ended September 30,2004. One customer represented 10.1% of revenues for the nine month periodended September 30, 2005, while one customer represented 11.5% of revenuesfor the nine month period ended September 30, 2004. Our top five customersrepresented 45.4% and 35.9% of revenue for the three month periods ended September 30,2005, and 2004, respectively. Our top five customers represented 35.6% and33.8% of revenue for the nine month periods ended September 30, 2005, and2004, respectively.

 

**Note 10. Corporate Affiliates**

 

Wehave made strategic investments in private companies located in China in orderto gain access to raw materials at a competitive cost that are critical to oursubstrate business. Our investments in these private corporate affiliates aresummarized below (in thousands):

 
| ** **                                     | ** ** | **Investment Balance as of** | ** ** | ** **                  | ** ** | ** **             | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|-----------------------------|------------|------------------------|------------|
| **Affiliate**                                  | ** ** | **September 30,  2005**      | ** ** | **December 31,  2004** | ** ** | **Accounting  Method** | ** ** | **Ownership  Percentage** | ** ** |
| Beijing Ji Ya Semiconductor Material Co.,  Ltd |       | $                                 | 1,071      |                        | $          | 1,071                  |       | Consolidated |   | 51 | % |
| Nanjing Jin Mei Gallium Co., Ltd               |       | 616                               |       | 616                         |       | Consolidated           |       | 88 |   |
| Beijing BoYu Manufacturing Co., Ltd            |       | 409                               |       | 409                         |       | Consolidated           |       | 70 |   |
| Xilingol Tongli Ge Co. Ltd                     |       | 849                               |       | 863                         |       | Equity                 |       | 25 |   |
| Emeishan Jia Mei High Pure Metals Co., Ltd     |       | 580                               |       | 593                         |       | Equity                 |       | 25 |   |
|                                                |            |                                   |            |                             |            |                        |            |  |  |  |  |

 

Theinvestment balances for the two affiliates accounted for under the equitymethod are included in other assets in the condensed consolidated balancesheets. We own 25% of the ownership interests in each of these affiliates.These two affiliates are not considered variable interest entities because:

 

•                       bothaffiliates have sustainable businesses of their own;

 

•                       our votingpower is proportionate to our ownership interests;

 

•                       we onlyrecognize our respective share of the losses and/or residual returns generatedby the affiliates if they occur, or both; and

 

•                       we do nothave controlling financial interests in either affiliate, do not maintainoperational or management control, nor control of the board of directors, andare not required to provide additional investment or financial support toeither affiliate.

 

Undistributedretained earnings relating to our corporate affiliates were $2.2 million and$1.4 million as of September 30, 2005 and 2004, respectively. Net income(loss) recorded from our corporate affiliates were $416,000 and ($4,000) forthe three month periods ended September 30, 2005 and 2004, respectively.Net income recorded from our corporate affiliates was $747,000 and $607,000 forthe nine month periods ended September 30, 2005 and 2004, respectively.

 

The minority interest for those affiliates that are consolidated isincluded within “Other long-term liabilities” in the condensed consolidatedbalance sheets and within “Other expense (income)” on the condensedconsolidated statements of operations.

 

13

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We have considered investments in other jointventures, including a new joint venture investment in China for agermanium business opportunity.  We arein the final negotiations process in forming this joint venture, and we may,upon the fulfillment of certain conditions, invest up to $2.5 million in thenew joint venture by mid-2006.

 

**Note11. Commitments and Contingencies**

 

***LegalMatters***

*** ***

On October 15, 2004, a purported securitiesclass action lawsuit was filed in the United States Court for the NorthernDistrict of California. City of Harper Woods Employees Retirement System v. AXT, Inc.et al., No. C 04 4362 MJJ.  TheCourt consolidated the case with a subsequent related case and appointed a leadplaintiff.  On April 5, 2005, thelead plaintiff filed a consolidated complaint, captioned as Morgan v. AXT, Inc.et al., No. C 04 4362 MJJ.  Thelawsuit complaint names AXT, Inc. and our chief technology officer, asdefendants, and is brought on behalf of a class of all purchasers of oursecurities from February 6, 2001 through April 27, 2004. Thecomplaint alleges that we announced financial results during this period thatwere false and misleading. No specific amount of damages is claimed.  We believe that there are meritoriousdefenses against this litigation and intend to vigorously defend it. On September 23,2005, the Court granted our motion to dismiss the complaint, with leave toamend. However, due to the inherent uncertainties of litigation, we cannotaccurately predict the ultimate outcome of the litigation. Any unfavorableoutcome of the litigation could have an adverse impact on our business,financial condition and results of operations.

 

On June 1, 2005, a lawsuit was filed in the Superior Court ofCalifornia, County of Alameda, *Zhao et. Al. vs. AmericanXtal Technology, et. al.*, No. R 605215713.  The lawsuit complaint names as defendantsAXT, its chief technology officer, its former interim chief executive officer,a former safety department employee and a supplier to AXT.  The lawsuit is brought on behalf of twoformer employees and their minor child. The complaint alleges personal injury, general negligence, intentionaltort, wage loss and other damages, including punitive damages, as a result ofexposure to the child while in utero to high levels of gallium arsenide andmethanol used in the production of gallium arsenide wafers.

 

We believe that there are meritorious defenses against this litigationand intend to vigorously defend it.  AXT’scommercial general liability insurance carrier has agreed to fund AXT’s defenseof the case, but has reserved the right to deny coverage, in whole or in part,in the future under selected policy provisions and applicable law.  There is $21 million in available limitsunder the policies in question. Due to the inherent uncertainties oflitigation, we cannot accurately predict the ultimate outcome of thelitigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.

 

***Indemnification Agreements***

 

Weenter into standard indemnification arrangements in the ordinary course ofbusiness. Pursuant to these arrangements, we indemnify, hold harmless, andagree to reimburse the indemnified parties for losses suffered or incurred bythe indemnified party, generally their business partners or customers, inconnection with any U.S. patent, or any copyright or other intellectualproperty infringement claim by any third party with respect to our products.The term of these indemnification agreements is generally perpetual anytimeafter the execution of the agreement. The maximum potential amount of futurepayments we could be required to make under these agreements is unlimited. Wehave never incurred costs to defend lawsuits or settle claims related to theseindemnification agreements. As a result, we believe the estimated fair value ofthese agreements is minimal.

 

Wehave entered into indemnification agreements with our directors and officersthat may require us to indemnify our directors and officers against liabilitiesthat may arise by reason of their status or service as directors or officers,other than liabilities arising from willful misconduct of a culpable nature; toadvance their expenses incurred as a result of any proceeding against them asto which they could be indemnified; and to obtain directors’ and officers’insurance if available on reasonable terms, which we currently have in place.

 

***ProductWarranty***

*** ***

Wewarrant our products for a specific period of time, generally twelve months,against material defects. We provide for the estimated future costs of warrantyobligations in cost of sales when the related revenue is recognized. Theaccrued warranty costs represent the best estimate at the time of sale of thetotal costs that we expect to incur to repair or replace product parts thatfail while still under warranty. The amount of accrued estimated warranty costsare primarily based on historical experience as to product failures as well ascurrent information on repair costs. On a quarterly basis, we review theaccrued balances and update these based on 

 

14

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the historical warranty cost trends. The following table reflects thechange in our warranty accrual during the three month and nine month periodsended September 30, 2005 and 2004 (in thousands):

 
| ** **                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                          |       |                                      |       |                                     |       |   |   |   |   |
| Beginning accrued warranty and related  costs |       | $                                         | 82         |                                     | $          | 135 |   | $ | 135 |   | $ | — |   |
| Charged to cost of revenue                    |       | (60                                       | )          | —                                   |       | (113 | ) | 135 |   |
| Actual warranty expenditures                  |       | —                                    |       | —                                   |       | — |   | — |   |
| Ending accrued warranty and related costs     |       | $                                         | 22         |                                     | $          | 135 |   | $ | 22 |   | $ | 135 |   |

 

***SalesReturns***

*** ***

InMarch 2004, we increased our reserve for repair and replacement costs by$745,000. Approximately $487,000 of the $745,000 sales returns reserve has beenutilized and approximately $205,000 has been reversed to revenue as of September 30,2005 as we favorably resolved an outstanding matter with a customer. We willcontinue to monitor the returns for this specific reserve.

 

**Note12. Foreign Exchange Contracts and Transaction Gains/Losses**

 

Weuse short-term forward exchange contracts for hedging purposes to reduce theeffects of adverse foreign exchange rate movements. We have purchased foreignexchange contracts to hedge against certain trade accounts receivabledenominated in Japanese yen. The change in the fair value of the forwardcontracts is recognized as part of the related foreign currency transactions asthey occur. As of September 30, 2005, we had no outstanding commitmentswith respect to foreign exchange contracts.

 

Weincurred a foreign currency transaction exchange loss of $61,000 for the threemonth period ended September 30, 2005, and a foreign currency exchangeloss of $23,000 for the three month period ended September 30, 2004. Weincurred a foreign currency transaction exchange loss of $110,000 for the ninemonth period ended September 30, 2005, and a foreign currency exchange lossof $34,000 for the nine month period ended September 30, 2004. Theseamounts are included in other income (expense), net on the condensedconsolidated statements of operation.

 

**Note13. Recent Accounting Pronouncements**

 

InNovember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 151 (“SFAS 151”), *InventoryCosts*,*an amendment of ARB No. 43,Chapter 4.* SFAS 151 amends the guidance in ARB No. 43, Chapter4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idlefacility expense, freight, handling costs, and wasted material (spoilage).Paragraph 5 of ARB 43, Chapter 4, previously stated that “...under somecircumstances, items such as idle facility expense, excessive spoilage, doublefreight, and rehandling costs may be so abnormal as to require treatment ascurrent period charges....” SFAS 151 requires that those items be recognized ascurrent period charges regardless of whether they meet the criterion of “soabnormal.” In addition, SFAS 151 requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities. The provisions of SFAS 151 are effective for inventorycosts incurred during fiscal years beginning after June 15, 2005. Theadoption of SFAS 151 is not expected to have a material effect on ourconsolidated financial position, results of operations or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 153 (“SFAS 153”), *“Exchanges of Nonmonetary Assets—An Amendment of APBOpinion No. 29, Accounting for Nonmonetary Transactions.”*SFAS 153 eliminates the exception from fair value measurement fornonmonetary exchanges of similar productive assets in paragraph 21(b) ofAPB Opinion No. 29, “Accounting for Nonmonetary Transactions,” andreplaces it with an exception for exchanges that do not have commercialsubstance. SFAS 153 specifies that a nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. SFAS 153 is effective for thefiscal periods beginning after June 15, 2005. We do not expect theadoption of SFAS 153 to have a material impact on our consolidatedfinancial position, results of operations or cash flows.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004) (“SFAS 123R”), *“Share-Based Payment,”* which requirescompanies to measure and recognize compensation expense for all stock-basedpayments at fair value. SFAS 123R was originally effective for all interimperiods beginning after June 15, 2005. Early adoption is encouraged andretroactive application of the provisions of SFAS 123R to the beginningof the fiscal year that includes the effective date is permitted, but notrequired.

 

15

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In March 2005,the U.S. Securities and Exchange Commission (“ SEC”), released Staff AccountingBulletin No. 107 (“SAB107”), *“Share-BasedPayments”* . The interpretations in SAB 107 express views of the SECstaff, regarding the interaction between SFAS 123R and certain SEC rules andregulations, and provide the staff’s views regarding the valuation ofshare-based payment arrangements for public companies. In particular, SAB 107provides guidance related to share-based payment transactions withnonemployees, the transition from nonpublic to public entity status, valuationmethods (including assumptions such as expected volatility and expected term),the accounting for certain redeemable financial instruments issued undershare-based payment arrangements, the classification of compensation expense,non-GAAP financial measures, first-time adoption of SFAS 123R in an interimperiod, capitalization of compensation cost related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS 123R, the modification of employee shareoptions prior to adoption of SFAS 123R and disclosures in Management’sDiscussion and Analysis subsequent to adoption of SFAS 123R.

 

In April 2005, the SECapproved a new rule that delays the effective date of SFAS 123R to thefirst annual or interim reporting period for fiscal years beginning on or afterJune 15, 2005.  SFAS123R will beeffective for us beginning with the first quarter of fiscal 2006.  We are currently evaluating the impact ofSFAS 123R on our consolidated financial position and results ofoperations. See Note 3. *Accounting for Stock-Based Compensation* forinformation related to the pro forma effects on our reported net loss and netloss per share when applying the fair value recognition provisions of theprevious SFAS No. 123, *“Accountingfor Stock-Based Compensation,”* to stock-based employee compensation.

 

In May 2005,the FASB issued SFAS No. 154 (“SFAS 154”), “*AccountingChanges and Error Corrections*”, which will require entities thatvoluntarily make a change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would be impracticable.SFAS 154 supersedes APB No. 20 (“APB 20”), Accounting Changes, whichpreviously required that most voluntary changes in accounting principle berecognized by including in the current period’s net income the cumulativeeffect of changing to the new accounting principle. SFAS 154 also makes adistinction between “retrospective application” of an accounting principle andthe “restatement” of financial statements to reflect the correction of anerror. Another significant change in practice under SFAS 154 will be that if anentity changes its method of depreciation, amortization, or depletion forlong-lived, non-financial assets, the change must be accounted for as a changein accounting estimate. Under APB 20, such a change would have been reported asa change in accounting principle. SFAS 154 applies to accounting changes anderror corrections that are made in fiscal years beginning after December 15,2005. We do not anticipate a material impact from the adoption of SFAS 154 onour consolidated financial position, results of operations, or cash flows.

 

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

This Management’s Discussion and Analysis of Financial Condition andResults of Operations includes a number of forward-looking statements madepursuant to the provisions of Section 21E of the Securities Exchange Actof 1934. These forward-looking statements are based upon management’s currentviews with respect to future events and financial performance, and are subjectto certain risks and uncertainties that could cause actual results to differmaterially from historical results or those anticipated. Such risks anduncertainties include those set forth under “Risks Related to our Business”below. Forward-looking statements may be identified by the use of terms such as“anticipates,” “believes,” “estimates,” “expects,” “intends,” and similarexpressions. Statements concerning our future or expected financial results andcondition, business strategy and plans or objectives for future operations areforward-looking statements.

 

These forward-looking statements are not guarantees of futureperformance. Readers are cautioned not to place undue reliance on these forward-lookingstatements, which speak only as of the date hereof. This discussion should beread in conjunction with Management’s Discussion and Analysis of FinancialCondition and Results of Operations included in our Annual Report on Form10-K for the year ended December 31, 2004 and the condensed consolidatedfinancial statements included elsewhere in this report.

 

**Overview**

 

We were founded in 1986 to commercialize and enhance our proprietaryvertical gradient freeze (VGF) technique for producing high-performancecompound semiconductor substrates. As a result of the discontinuance of ouropto-electronics division, and the sale of substantially all of the assets ofthis business in 2003, we now have one operating segment: our substratedivision. We made our first substrate sales in 1990 and our substrate divisioncurrently sells gallium arsenide (GaAs) and indium phosphide (InP) substratesto manufacturers of semiconductor devices for use in applications such as fiberoptic and wireless telecommunications, light emitting diodes (LEDs) and lasers.We also sell raw materials including gallium and germanium through ourparticipation in majority- and minority-owned joint ventures. We have thecapability to manufacture germanium substrates for use in satellite solar cellsbut withdrew from this business during 2000 so that we could more profitablyuse our then constrained capacity. We are in the process of re-qualifying ourgermanium substrates with the few existing satellite solar cell systemmanufacturers.

 

Revenues from continuing operations decreasedfor the three month period ended September 30, 2005 compared to the sameperiod of fiscal 2004. In response to continued net losses, we have takenmeasures including the shifting of production to China to reduce costs andcontrol cash flows. As of September 30, 2005, we had available cash, cashequivalents and short-term investments of $24.2 million, excluding restricteddeposits. We believe that our existing cash and cash equivalents and short-terminvestments, together with additional efforts to reduce expenditures in supportof the continuing substrate business will be sufficient to meet working capitalrequirements for the next twelve months. However, existing cash and cashequivalents and short-term investments could decline during the remainder of2005 due to a weakening of the economy, a loss in revenue, an unanticipatedincrease in expenses, or changes in our planned cash outlay.

 

If our performance fails to improve, we willcontinue to use cash and may at some time be forced to seek additional capital.There can be no assurance that additional capital will be available or, ifavailable to us,that it will be at terms acceptable to us.

 

***DiscontinuedOpto-Electronics Business***

*** ***

InJune 2003, we announced the discontinuation of our opto-electronicsdivision, which we had established as part of our acquisition of Lyte Optronics, Inc.in May 1999. The discontinued opto-electronics division manufactured blue,cyan, and green high-brightness light emitting diodes (HBLEDs) for theillumination markets, and also manufactured vertical cavity surface emittinglasers (VCSELs) and laser diodes for fiber optic communications and storagearea networks. Accordingly, the results of operations of the opto-electronicsdivision have been segregated from continuing operations and are reportedseparately as discontinued operations in our condensed consolidated statementsof operations for all periods presented. See Note 2 to our condensedconsolidated financial statements for details regarding the accounting fordiscontinued operations.

 

InSeptember 2003, we completed the sale of substantially all of the assetsof our opto-electronics business to Lumei Optoelectronics Corp. (Lumei) andDalian Luming Science and Technology Group, Co., Ltd. for the Chinese Renminbi(RMB) equivalent of $9.6 million. A portion of the purchase price equal to $1.0million was held in escrow to satisfy any 

 

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claimsthat the purchaser might make for breaches of representations or warranties byus. Of this total escrow $750,000 could be released after the one yearanniversary of the sale of the opto-electronics business and the remaindercould be released after the second anniversary of the sale. To date, we haveresolved all claims made against the $1.0 million that was held in escrow. Forthe three month period ended September 30, 2005, we recorded a gain forthe final $250,000 that was held in escrow and a $9,000 gain from interest. Forthe nine month period ended September 30, 2005 we recorded $550,000 ingains from escrow, a $9,000 gain from interest, and $58,000 in property taxrefunds.

 

InJune 2005, we completed the sale of a building located in Monterey Park,California. This asset had been classified as “assets held for sale” in theamount of $1.25 million on the condensed consolidated balance sheets as of December 31,2004. We received net proceeds on the sale of the property of approximately$1.3 million and accordingly recorded a gain on sale of $53,000 in the quarterended June 30, 2005.

 

***RestructuringCharges***

*** ***

During the second quarter of 2004, weannounced plans to cease all production activities in the United States and tomanufacture our products only in China. In June 2004, we incurred arestructuring charge of $1.1 million as a result of our decision to close downour remaining manufacturing facilities in the United States. In the third andfourth quarter of 2004, we incurred additional restructuring charges of$231,000 for a total of $1.3 million in 2004. These charges comprised costsrelated to the reduction in work force effected in June 2004, and leasecosts associated with the facilities located in California that are no longerrequired to support production. In aggregate, we eliminated 50 positions, 47 ofwhich were production workers. On an annual basis, we anticipate payroll andrelated expense savings of $1.5 million. On March 14, 2005, we announced areduction of our workforce at our Beijing, China manufacturing facility ofapproximately 100 positions or approximately 15%. This measure was taken aspart of our ongoing effort to reduce our cost structure and bring capacity inline with current market demand. We recorded a restructuring charge of $56,000in the nine month period ended September 30, 2005 relating to thereduction in force, which we completed in March 2005. On an annual basis,we anticipate payroll and related expense savings of approximately $0.3 millionrelating to this reduction in force.

 

On April 28, 2005, we closed our Japan officeas part of our ongoing effort to reduce our cost structure. Through September,2005 we recorded a restructuring charge of $107,000 relating to the closure ofour Japan office. On an annual basis, we anticipate payroll and related expensesavings of approximately $0.3 million relating to the closure of our Japanoffice.

 

For the three and nine month periods ended September 30,2005 we recorded restructuring charges of $5,000 and $213,000,respectively, related to leasecosts associated with facilities located in California that are no longerrequired to support production. The remaining restructuring accrual for futurelease payments related to abandoned U.S. facilities of $375,000 is expected tobe paid out through 2006, and is included on the accompanying condensedconsolidated balance sheet as accrued restructuring.

 

Forthe remainder of 2005, we will continue to reduce costs by qualifying new lowercost suppliers, moving more of our administrative functions to China where ourcosts are lower, and streamlining our organization structure and costs in theUnited States and China to bring them in line with our current business.

 

**CriticalAccounting Policies and Estimates**

 

We have prepared our condensed consolidatedfinancial statements in accordance with accounting principles generallyaccepted in the United States of America. As such, we have had to makeestimates, assumptions and judgments that affect the amounts reported on ourfinancial statements. These estimates, assumptions and judgments about futureevents and their effects on our results cannot be determined with certainty,and are made based upon our historical experience and on other assumptions thatare believed to be reasonable under the circumstances. These estimates maychange as new events occur or additional information is obtained, and we mayperiodically be faced with uncertainties, the outcomes of which are not withinour control and may not be known for a prolonged period of time. The discussionand analysis of our results of operations and financial condition are basedupon these condensed consolidated financial statements. We have identified thepolicies below as critical to our business operations and understanding of ourfinancial condition and results of operations. A critical accounting policy isone that is both material to the presentation of our financial statements andrequires us to make difficult, subjective or complex judgments that could havea material effect on our financial condition and results of operations. They mayrequire us to make assumptions about matters that are highly uncertain at thetime of the estimate, and different estimates that we could have used, orchanges in the estimate that are reasonably likely to occur, may have amaterial impact on our financial condition or results of operations.

 

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We believe that the following are our critical accounting policies:

 

***Revenue Recognition***

 

We manufacture and sell high-performancecompound semiconductor substrates and sell certain raw materials includinggallium, germanium dioxide, and pBN crucibles. After we ship our products,there are no remaining obligations or customer acceptance requirements thatwould preclude recognition of the revenue earned on the sale. Our products aretypically sold pursuant to a purchase order placed by our customers, and ourterms and conditions of sale do not require customer acceptance. We recognizerevenue upon shipment and transfer of title of products to our customers, whichis either upon shipment from our dock, receipt at the customer’s dock, orremoval from consignment inventory at the customer’s location, provided that wehave received a signed purchase order, the price is fixed or determinable,title and risk of ownership have transferred, collection of resultingreceivables is probable, and product returns are reasonably estimable. We donot provide training, installation or commissioning services. Additionally, wedo not provide discounts or other incentives to customers except for onecustomer with whom we agreed in the fourth quarter of 2004 to provide acertain amount of cumulative discounts on future product purchases from us. Wewill recognize these discounts in future periods as a reduction in revenue asproducts are sold to this customer.

 

We provide for future returns based onhistorical experience, current economic trends and changes in customer demandat the time revenue is recognized. In the first quarter of 2004, we recorded areserve for sales returns of $745,000 related to our failure to follow certaintesting requirements and provision of testing data and information to certaincustomers. This reserve was based on discussions with some of the affectedcustomers and review of specific shipments. Approximately $487,000 of the$745,000 sales returns reserve had been utilized and approximately $205,000 hasbeen reversed to revenue as of September 30, 2005 as we favorably resolvedan outstanding matter with a customer. We will continue to monitor the returnsfor this specific reserve.

 

***Allowance for Doubtful Accounts***

 

We periodically review the likelihood ofcollection on our accounts receivable balances and provide an allowance fordoubtful accounts receivable primarily based upon the age of these accounts. Weprovide a 100% allowance for U.S. receivables in excess of 90 days and forforeign receivables in excess of 120 days. We assess the probability ofcollection based on a number of factors, including the length of time areceivable balance has been outstanding, our past history with the customer andtheir credit worthiness.

 

As of September 30, 2005 and December 31,2004, our accounts receivable balance was $4.9 million and $4.0 million,respectively, which was net of an allowance for doubtful accounts of $0.3million and $1.1 million, respectively. If actual uncollectible accounts differ substantially from ourestimates, revisions to the estimated allowance for doubtful accounts would berequired, which could have a material impact on our financial results for theperiod.

 

***Warranty Reserve***

 

We maintain a warranty reserve based upon ourclaims experience during the prior twelve months. Warranty costs are accrued atthe time revenue is recognized. As of September 30, 2005, accrued productwarranties totaled $22,000. If actual warranty costs differ substantially fromour estimates, revisions to the estimated warranty liability would be required,which could have a material impact on our financial condition and results ofoperations.

 

***Inventory Valuation***

 

Inventories are stated at the lower of costor market. Cost is determined using the weighted average cost method. Ourinventory consists of raw materials as well as finished goods andwork-in-process that include material, labor and manufacturing overhead costs.Given the nature of our substrate products, and the materials used in themanufacturing process, the wafers and ingots comprising work-in-process may beheld in inventory for up to two years and three years, respectively, as therisk of obsolescence for these materials is low. We routinely evaluate thelevels of our inventory in light of current market conditions in order toidentify excess and obsolete inventory and provide a valuation allowance forcertain inventories based upon the age and quality of the product and theprojections for sale of the completed products. As of September 30, 2005,we had an inventory reserve of $17.5 million for excess and obsolete inventory.The majority of this inventory has not been scrapped. If actual demand for ourproducts were to be substantially lower than estimated, additional inventoryadjustments for excess or obsolete inventory might be required, which couldhave a material impact on our business, financial condition and results ofoperations.

 

***Impairment of Investments***

 

We classify our investments in debt andequity securities as available-for-sale securities as prescribed by Statementof Financial Accounting Standards (“SFAS”) No. 115, *“Accounting for Certain Investments in Debt andEquity Securities.”* All available-for-sale securities with a quotedmarket value below cost (or adjusted cost) are reviewed in order to determinewhether the decline is other-than-temporary. Factors considered in determiningwhether a loss is temporary include the magnitude of the decline in marketvalue, the length of time the market value has been below cost (or adjustedcost), credit quality, and our ability and intent to hold the securities for aperiod of time sufficient to allow for any anticipated recovery in marketvalue.

 

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We invest in equity instruments ofprivately-held companies for business and strategic purposes. These investmentsare classified as other assets and are accounted for under the cost method aswe do not have the ability to exercise significant influence over theiroperations. We monitor our investments for impairment and record reductions incarrying value when events or changes in circumstances indicate that thecarrying value may not be recoverable. Determination of impairment is highlysubjective and is based on a number of factors, including an assessment of thestrength of investee’s management, the length of time and extent to which thefair value has been less than our cost basis, the financial condition andnear-term prospects of the investee, fundamental changes to the businessprospects of the investee, share prices of subsequent offerings, and our intentand ability to hold the investment for a period of time sufficient to allow forany anticipated recovery in our carrying value.

 

***Impairment of Long-Lived Assets***

 

We evaluate the recoverability of property,equipment, and intangible assets in accordance with SFAS No. 144, *“Accounting for the Impairment or Disposal ofLong-Lived Assets.”* When events and circumstances indicate thatlong-lived assets may be impaired, we compare the carrying value of thelong-lived assets to the projection of future undiscounted cash flowsattributable to such assets. In the event that the carrying value exceeds thefuture undiscounted cash flows, we record an impairment charge against incomeequal to the excess of the carrying value over the asset’s fair value.

 

***Employee Stock Options***

 

We grant options to substantially allmanagement employees and believe that this broad-based program helps us toattract, motivate, and retain high quality employees, to the ultimate benefitof our stockholders. We currently account for share-based payments to employeesusing the intrinsic value method under APB Opinion No. 25 and, as such,generally recognize no compensation cost for employee stock options. SFAS No. 123(revised), “Share-Based Payment” (“SFAS 123R”) will be effective for usbeginning with the first quarter of fiscal 2006.  The adoption of SFAS 123R is expected toresult in a material increase in expense during fiscal 2006 based on unvestedoptions outstanding as of September 30, 2005 and current compensationplans. While the effect of adoption depends on the level of share-basedpayments granted in the future and unvested grants on the date we adopt SFAS123(R), the effect of this accounting standard on our prior operating resultswould approximate the effect of SFAS 123 as described in the disclosure of proforma net loss and net loss per share. See Note 3 to our condensed consolidatedfinancial statements.

 

***Income Taxes***

 

We account for income taxes in accordancewith SFAS No. 109 (“SFAS 109”), *“Accountingfor Income Taxes,”* which requires that deferred tax assets andliabilities be recognized using enacted tax rates for the effect of temporarydifferences between the book and tax bases of recorded assets and liabilities.SFAS 109 also requires that deferred tax assets be reduced by a valuationallowance if it is more likely than not that a portion of the deferred taxasset will not be realized.

 

We provide for income taxes based upon thegeographic composition of worldwide earnings and tax regulations governing eachregion, particularly China. The calculation of tax liabilities involvessignificant judgment in estimating the impact of uncertainties in theapplication of complex tax laws, particularly in foreign countries such asChina.

 

**Resultsof Operations**

 

**Revenue**

 
| ** **     | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **     | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **     | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs           |       | $                                          | 5,353      |         | $          | 7,043          |       | $ | (1,690 | ) | (24.0 | )% |
| InP            |       | 234                                        |       | 214          |       | 20             |       | 9.3 | % |
| Raw Materials  |       | 578                                        |       | 1,230        |       | (652           | )          | (53.0 | )% |
| Other          |       | (12                                        | )          | 44           |       | (56            | )          | (127.3 | )% |
| Total  revenue |       | $                                          | 6,153      |         | $          | 8,531          |       | $ | (2,378 | ) | (27.9 | )% |

 

Revenue from continuing operations decreased $2.4 million, or 27.9%, to$6.2 million for the three month period ended September 30, 2005 comparedwith $8.5 million for the three month period ended September 30, 2004.Total GaAs substrate revenue decreased $1.7 million, or 24.0%, to $5.4 millionfor the three month period ended September 30, 2005 compared with $7.0million for the three month period ended September 30, 2004.

 

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Sales of 2 inch and 3 inch diameter GaAs substrates were $2.1 millionfor the three month period ended September 30, 2005 compared with $4.7million for the three month period ended September 30, 2004. The decreasein GaAs substrate revenue is due to the continuing pricing pressures causingaverage sales prices to decline, overall lower demand from our wirelessapplication customers and a decline in orders from customers who have not yetqualified our China-grown products. Sales of 5 inch and 6 inch diameter GaAssubstrates were $1.6 million for the three month period ended September 30,2005 compared with $0.5 million for the three month period ended September 30,2004. The increase in larger diameter substrate revenue is due to an increasein orders from customers who have now qualified our China-grown products.

 

Raw material sales revenue decreased $652,000, or 53.0%, to $578,000for the three month period ended September 30, 2005 compared with $1.2million for the three month period ended September 30, 2004. The decreasein raw material sales revenue was due to a decline in seasonal demand for gallium,as well as the timing of certain customer orders that fell into the fourthquarter of 2005.

 
| ** **     | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **     | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **     | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| GaAs           |       | $                                         | 15,033     |         | $          | 22,579         |       | $ | (7,546 | ) | (33.4 | )% |
| InP            |       | 651                                       |       | 1,263        |       | (612           | )          | (48.5 | )% |
| Raw Materials  |       | 3,130                                     |       | 3,905        |       | (775           | )          | (19.8 | )% |
| Other          |       | 5                                         |       | 84           |       | (79            | )          | (94.0 | )% |
| Total  revenue |       | $                                         | 18,819     |         | $          | 27,831         |       | $ | (9,012 | ) | (32.4 | )% |

 

Revenue from continuing operations decreased $9.0 million, or 32.4%, to$18.8 million for the nine month period ended September 30, 2005 comparedwith $27.8 million for the nine month period ended September 30, 2004.

 

Total GaAs substrate revenue decreased $7.5 million, or 33.4%, to $15.0million for the nine month period ended September 30, 2005 compared with$22.6 million for the nine month period ended September 30, 2004. Sales of2 inch and 3 inch diameter GaAs substrates were $8.5 million for the nine monthperiod ended September 30, 2005 compared with $14.0 million for the ninemonth period ended September 30, 2004. The decrease in GaAs substraterevenue is due to the continuing pricing pressures causing average sales pricesto decline, overall lower demand from our wireless application customers and adecline in orders from customers who have not yet qualified our China-grownproducts. InP substrate revenue decreased $612,000, or 48.5%, to $651,000 forthe nine month period ended September 30, 2005 compared with $1.3 millionfor the nine month period ended September 30, 2004. The decrease in InPsubstrate revenue was due to a decline in orders from customers who are havenot yet qualified our China-grown products. Raw material sales revenuedecreased $775,000, or 19.8%, to $3.1 million for the nine month period ended September 30,2005 compared with $3.9 million for the nine month period ended September 30,2004. The decrease in raw material sales revenue was due to a decline in demandfor gallium, as well as the timing of certain customer orders that fell intothe fourth quarter of 2005.

 

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***Revenueby Geographic Region***

 
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| North America *                           |       | $                                          | 1,481      |         | $          | 1,873          |       | $ | (392 | ) | (20.9 | )% |
| *% of  total revenue*                     |       | 24                                         | %          | 22           | %          |           |       |   |   |
| Europe                                    |       | 1,328                                      |       | 1,731        |       | (403           | )          | (23.3 | )% |
| *% of  total revenue*                     |       | 22                                         | %          | 20           | %          |           |       |   |   |
| Japan                                     |       | 1,087                                      |       | 1,274        |       | (187           | )          | (14.7 | )% |
| *% of  total revenue*                     |       | 18                                         | %          | 15           | %          |           |       |   |   |
| Taiwan                                    |       | 704                                        |       | 1,940        |       | (1,236         | )          | (63.7 | )% |
| *% of  total revenue*                     |       | 11                                         | %          | 23           | %          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 1,553                                      |       | 1,713        |       | (160           | )          | (9.3 | )% |
| *% of  total revenue*                     |       | 25                                         | %          | 20           | %          |           |       |   |   |
| Total  revenue                            |       | $                                          | 6,153      |         | $          | 8,531          |       | $ | (2,378 | ) | (27.9 | )% |

 

----

*                 Primarilythe United States

 

The Taiwan revenue decreased by $1.2 million or 63.7%, to $0.7 millionfor the three month period ended September 30, 2005 compared with $1.9million for the three month period ended September 30, 2004. One majorcustomer’s purchases decreased by $0.9 million specifically due to quality issuesin our 2 inch prime semi-conducting wafers. The overall decrease in othergeographic areas for our GaAs substrates is due to continuing pricing pressurescausing average sales prices to decline, overall lower demand from our wirelessapplication customers, and delays in orders from customers who have not yetqualified our China-grown products.

 
| ** **                                | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| * *                                  |       | **($ in thousands)**            |       |         |       |           |       |
| North America *                           |       | $                                         | 3,684      |         | $          | 6,163          |       | $ | (2,479 | ) | (40.2 | )% |
| *% of  total revenue*                     |       | 20                                        | %          | 22           | %          |           |       |   |   |
| Europe                                    |       | 4,911                                     |       | 5,433        |       | (522           | )          | (9.6 | )% |
| *% of  total revenue*                     |       | 26                                        | %          | 20           | %          |           |       |   |   |
| Japan                                     |       | 1,887                                     |       | 3,534        |       | (1,647         | )          | (46.6 | )% |
| *% of  total revenue*                     |       | 10                                        | %          | 13           | %          |           |       |   |   |
| Taiwan                                    |       | 2,840                                     |       | 7,623        |       | (4,783         | )          | (62.7 | )% |
| *% of  total revenue*                     |       | 15                                        | %          | 27           | %          |           |       |   |   |
| Asia Pacific (excluding Japan and Taiwan) |       | 5,497                                     |       | 5,078        |       | 419            |       | 8.3 | % |
| *% of  total revenue*                     |       | 29                                        | %          | 18           | %          |           |       |   |   |
| Total  revenue                            |       | $                                         | 18,819     |         | $          | 27,831         |       | $ | (9,012 | ) | (32.4 | )% |

 

----

*                 Primarilythe United States

 

International revenue increased to 80% of total revenue from continuingoperations for the nine month period ended September 30, 2005 comparedwith 78% of total revenue from continuing operations for the nine month periodended September 30, 2004. Asia Pacific (excluding Japan and Taiwan)revenue increased to 29% of total revenue from continuing operations for thenine month period ended September 30, 2005 compared with 18% of totalrevenue from continuing operations for the nine month period ended September 30,2004. The increase was primarily due to increased sales of GaAs substrates tocustomers in China and Singapore which are being used in opto-electronicsapplications. The Taiwan revenue decreased by $4.8 million or 62.7%, to $2.8million for the nine month period ended September 30, 2005 compared with$7.6 million for the nine month period ended September 30, 2004. Thedecrease in Taiwan and other geographic areas for our GaAs substrates is due tocontinuing pricing pressures causing average sales prices to decline, overalllower demand from our wireless application customers, and delays in orders fromcustomers who have not yet qualified our China-grown products.

 

22

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***GrossMargin***

 
| ** **        | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                                          | 1,145      |         | $          | (2,236         | )          | $ | 3,381 |   | (151.2 | )% |
| *Gross  Margin %* |       | 18.6                                       | %          | (26.2        | )%         |           |       |   |   |
|                   |            |                                            |            |              |            |                |            |  |  |  |  |  |

 

*Gross margin.*Grossmargin increased to 18.6% of total revenue for the three month period ended September 30,2005 compared with negative 26.2% of total revenue for the three month periodended September 30, 2004. Gross margin in the three month period ended September 30,2005 was positively impacted by sales of approximately $686,000 of galliumarsenide (GaAs) wafers which were previously fully reserved, and byapproximately $205,000 as a result of a reversal of a sales return reserveestablished in 2004 as we favorably resolved an outstanding matter with acustomer. Gross margin was (26.2)% of total revenue for the three months ended September 30,2004 primarily due to an approximately $1.4 million charge in connection withthe settlement of our litigation in Japan and interference actions in theUnited States with Sumitomo Electrical Industries, Ltd. and a $2.1 millioninventory valuation charge due to excess and obsolete inventory.

 
| ** **        | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **        | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **        | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gross profit      |       | $                                         | 1,551      |         | $          | (874           | )          | $ | 2,425 |   | (277.5 | )% |
| *Gross  Margin %* |       | 8.2                                       | %          | (3.1         | )%         |           |       |   |   |
|                   |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

*Gross margin.*Grossmargin increased to 8.2% of total revenue for the nine month period ended September 30,2005 compared with negative 3.1% of total revenue for the nine month periodended September 30, 2004. Gross margin in the nine month period ended September 30,2005 was positively impacted by sales of approximately $1.5 million of galliumarsenide (GaAs) wafers which were previously fully reserved, and byapproximately $205,000 as a result of a reversal of a sales return reserveestablished in 2004 as we favorably resolved an outstanding matter with acustomer, offset by the negative impact of a $765,000 charge to cost ofrevenues as a result of an inventory valuation adjustment, as well as a declinein our average selling prices. Gross margin was (3.1)% of total revenue for thenine months ended September 30, 2004 primarily due to an approximately$1.4 million charge in connection with the settlement of our litigation inJapan and interference actions in the United States with Sumitomo ElectricalIndustries, Ltd. and a $2.1 million inventory valuation charge due to excessand obsolete inventory.

 

***Selling,General and Administrative Expenses***

 
| ** **                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative  expenses |       | $                                          | 2,898      |         | $          | 2,468          |       | $ | 430 |   | 17 | % |
| *% of  total revenue*                         |       | 47.1                                       | %          | 28.9         | %          |           |       |   |   |
|                                               |            |                                            |            |              |            |                |            |  |  |  |  |  |

 

Selling, general and administrative expenses increased $430,000 to $2.9million for the three month period ended September 30, 2005 compared with$2.5 million for the three month period ended September 30, 2004. Thisincrease comprised approximately $191,000 for severance pay, $110,000 foradditional professional fees related to 

 

23

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implementationof Sarbanes-Oxley compliance and other matters, and $77,000 for increasedpersonnel costs in connection with our hiring of a new chief operating officer,vice president of global sales and marketing, and senior director of sales aswe restructured our sales organization beginning the second half of 2005.

 
| ** **                                    | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                    | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Selling, general and administrative  expenses |       | $                                         | 9,866      |         | $          | 8,441          |       | $ | 1,425 |   | 16.9 | % |
| *% of  total revenue*                         |       | 52.4                                      | %          | 30.3         | %          |           |       |   |   |
|                                               |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

Selling, general and administrative expenses increased $1.4 million to$9.9 million for the nine month period ended September 30, 2005 comparedwith $8.4 million for the nine month period ended September 30, 2004. Theincrease was primarily due to $1.8 million of expenses for the nine monthperiod ended September 30, 2005 relating to the decommissioning of ourFremont, California facilities, partially offset by $350,000 of legal fees and$300,000 of audit and Sarbanes-Oxley related expenses for the nine month periodended September 30, 2004.

 

***Researchand Development***

 
| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                                          | 472        |         | $          | 397            |       | $ | 75 |   | 18.9 | % |
| *% of  total revenue*    |       | 7.7                                        | %          | 4.7          | %          |           |       |   |   |
|                          |            |                                            |            |              |            |                |            |  |  |  |  |  |

 

Research and development expenses increased $75,000, or 18.9%, to$472,000 for the three month period ended September 30, 2005 compared with$397,000 for the three month period ended September 30, 2004, as a resultof our appointing Dr. Morris Young as our Chief Technology Officer toenhance our technology leadership.

 
| ** **               | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|--------------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **               | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **               | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Research and development |       | $                                         | 1,257      |         | $          | 1,088          |       | $ | 169 |   | 15.5 | % |
| *% of  total revenue*    |       | 6.7                                       | %          | 3.9          | %          |           |       |   |   |
|                          |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

Research and development expenses increased $169,000, or 15.5%, to $1.3million for the nine month period ended September 30, 2005, compared with$1.1 million for the nine month period ended September 30, 2004. Duringthe nine month period ended September 30, 2005, we incurred $64,000 inseverance pay to employees that had been performing research and developmentactivities. We believe that continued investment in product development iscritical to attaining our strategic objectives of maintaining and enhancing ourtechnology leadership, and have therefore appointed Dr. Morris Young asour Chief Technology Officer. As a result, we expect research and developmentexpenses to remain at the levels of recent quarters or to increase in futureperiods. Research and development efforts during the first nine months of 2005were focused primarily on improving the yield and surface quality of our GaAssubstrates, and we expect these activities to continue.

 

24

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***Restructuring Charges***

 
| ** **            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring charges |       | $                                          | 14         |         | $          | 158            |       | $ | (144 | ) | (91.1 | )% |
| *% of  total revenue* |       | 0.2                                        | %          | 1.9          | %          |           |       |   |   |
|                       |            |                                            |            |              |            |                |            |  |  |  |  |  |

 

During the three month period ended September 30, 2005, werecorded restructuring charges of $14,000 of which $5,000 related to lease costs associated with facilitieslocated in California that are no longer required to support production, and$9,000 related to the closure of ourJapan office. In September 2004, we recorded restructuring chargesof $158,000 of which $82,000 related to lease costs associated with facilities located in California that areno longer required to support production, and $76,000 as a result of our decisionto close down our remaining manufacturing facilities in the United States.

 
| ** **            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Restructuring charges |       | $                                         | 376        |         | $          | 1,235          |       | $ | (859 | ) | (69.6 | )% |
| *% of total  revenue* |       | 2.0                                       | %          | 4.4          | %          |           |       |   |   |
|                       |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

During the nine month period ended September 30, 2005, we recordedrestructuring charges of $376,000, of which $213,000 related to lease costs associated with facilitieslocated in California that are no longer required to support production,$107,000 related to the closure of ourJapan office, and $56,000 related to the reduction in our China workforce effected in March 2005. In the nine month period ended September 2004,we recorded restructuring charges of $1.2 million of which $772,000 related tolease costs associated withfacilities located in California that are no longer required to supportproduction, and $463,000 as a result of our decision to close down ourremaining manufacturing facilities in the United States.

 

***InterestIncome, net***

 
| ** **            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net  |       | $                                          | 136        |         | $          | 95             |       | $ | 41 |   | 43.2 | % |
| *% of  total revenue* |       | 2.2                                        | %          | 1.1          | %          |           |       |   |   |
|                       |            |                                            |            |              |            |                |            |  |  |  |  |  |

 

Interest income, net increased $41,000 to $136,000 for the three monthperiod ended September 30, 2005 compared with $95,000 for the three monthperiod ended September 30, 2004 as a result of lower debt levels as wecontinued to pay down our debt.

 
| ** **            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **            | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Interest income, net  |       | $                                         | 386        |         | $          | 173            |       | $ | 213 |   | 123.1 | % |
| *% of  total revenue* |       | 2.1                                       | %          | 0.6          | %          |           |       |   |   |
|                       |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

Interest income, net increased $213,000 to $386,000 for the nine monthperiod ended September 30, 2005 compared with $173,000 for the nine monthperiod ended September 30, 2004 as a result of our lower debt levels as wecontinued to pay down our debt.

 

25

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***Other Income andExpense, net***

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income (expense) net |       | $                                          | (193       | )            | $          | 225            |       | $ | (418 | ) | -185.8 | % |
| *% of  total revenue*      |       | (3.1                                       | )%         | 2.6          | %          |           |       |   |   |
|                            |            |                                            |            |              |            |                |            |  |  |  |  |  |

 

Other expense was $193,000 for the three month period ended September 30,2005 compared with other income of $225,000 for the three month period ended September 30,2004. The change from other income to other expense was mainly due to adecrease in the minority interest’s share in our joint ventures of $90,000,foreign exchange losses related to the Japanese yen of $38,000, and $237,000 ofother income in September 2004 received from a customer to terminate asupply guarantee contract.

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Other income (expense) net |       | $                                         | (494       | )            | $          | 34             |       | $ | (494 | ) | (1,452.9 | )% |
| *% of  total revenue*      |       | (2.6                                      | )%         | (0.1         | )%         |           |       |   |   |
|                            |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

Other expense was $494,000 for the nine month period ended September 30,2005 compared with other income of $34,000 for the nine month period ended September 30,2004. The change from other income to other expense was mainly due to adecrease in the minority interest’s share in our joint ventures of $101,000,foreign exchange losses related to the Japanese yen of $125,000, and $237,000of other income in September 2004 received from a customer to terminate asupply guarantee contract.

 

***Provisionfor Income Taxes***

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                                          | 45         |         | $          | 40             |       | $ | 5 |   | 12.5 | % |
| *% of  total revenue*      |       | 0.7                                        | %          | 0.5          | %          |           |       |   |   |
|                            |            |                                            |            |              |            |                |            |  |  |  |  |  |

*** ***

We provided for income taxes of $45,000 for our overseas businesses forthe three month period ended September 30, 2005 compared to $40,000 forthe three month period ended September 30, 2004.

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|----------------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                 | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Provision for income taxes |       | $                                         | 98         |         | $          | 177            |       | $ | (79 | ) | (44.6 | )% |
| *% of  total revenue*      |       | 0.5                                       | %          | 0.6          | %          |           |       |   |   |
|                            |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

We provided for income taxes of $98,000 for our overseas businesses forthe nine month period ended September 30, 2005 compared to $177,000 forthe nine month period ended September 30, 2004.

 

26

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***Gain from DiscontinuedOperations***

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **($ in thousands)**             | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from discontinued operations |       | $                                          | 259        |         | $          | 225            |       | $ | 34 |   | 15.1 | % |
| *% of  total revenue*             |       | 4.2                                        | %          | 2.6          | %          |           |       |   |   |
|                                   |            |                                            |            |              |            |                |            |  |  |  |  |  |

 

During the three monthperiod ended September 30, 2005, we recorded a gain on discontinuedoperations for the release of the remaining $250,000 that was held in escrow onthe sale of our opto-electronics business to Lumei Optoelectronics Corp. The$250,000 was held in escrow to satisfy any claims that the purchaser might makefor breaches of representations or warranties by us, and was released in September 2005,with approximately $9,000 in accrued interest. During the three month period ended September 30, 2004, we recordeda gain on discontinued operations for the release of $225,000 that was held inescrow on the sale of our opto-electronics business to Lumei OptoelectronicsCorp.

 
| ** **                        | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase** | ** ** | ** **     | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                        | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **($ in thousands)**            | ** ** | ** **   | ** ** | ** **     | ** ** |
| Gain from discontinued operations |       | $                                         | 670        |         | $          | 447            |       | $ | 223 |   | 49.9 | % |
| *% of  total revenue*             |       | 3.6                                       | %          | 1.6          | %          |           |       |   |   |
|                                   |            |                                           |            |              |            |                |            |  |  |  |  |  |

 

For the nine monthperiod ended September 30, 2005, the gain from discontinued operations ismade up of a gain of $300,000 which was the remaining portion of the first$750,000 held in escrow due to us from the sale of our opto-electronicsbusiness, $58,000 in property tax refunds, and a gain of $53,000 from the saleof a building located in Monterey Park, California, and the remaining $250,000that was held in escrow on the sale of our opto-electronics business to LumeiOptoelectronics Corp. The final $250,000 was released in September 2005,with approximately $9,000 in accrued interest.

 

For the nine monthperiod ended September 30, 2004, we recorded a gain on discontinuedoperations for the release of $225,000 that was held in escrow on the sale ofour opto-electronics business to Lumei Optoelectronics Corp, and we recorded again of $222,000 as a result of our reversal of accrued liabilities of generaland administrative expenses no longer required in connection with legal feesand cleanup costs.

 

**Liquidity and Capital Resources**

 

We consider cash and cash equivalents and short-term investments asliquid and available for use. Short-term investments are comprised ofgovernment bonds and high-grade commercial debt instruments. Also included inshort-term investments is our investment in common stock of FinisarCorporation. As of September 30, 2005, our principal sources of liquiditywere $24.2 million in cash and cash equivalents and short-term investments,excluding restricted deposits.

 

Cash and cash equivalents and short-term investments decreased $8.0million to $24.2 millionas of September 30, 2005 compared with $32.2 million as of December 31,2004. Of this decrease, $1.1 million was the decrease in our investment inFinisar common stock from $2.7 million as of December 31, 2004 to $1.6million as of September 30, 2005, and $1.9 million was our payment toSumitomo Electric Industries, Ltd. consisting of $1.4 million in connectionwith our settlement agreement and $0.5 million relating to our cross-licensefee.

 

Net cash used by operating activities of $6.1 million for the ninemonth period ended September 30, 2005 was comprised primarily of our netloss of $9.5 million, adjusted for non-cash items consisting primarily ofdepreciation of $2.9 million, and partially offset by a net increase of$273,000 in assets and liabilities. The net increase in assets and liabilities resultedprimarily from a decrease in accrued liabilities, an increase in accountsreceivable, net and partially offset by a decrease in net inventory and a decrease inprepaid expenses.

 

27

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Net accounts receivable increased by $0.9 million, or 21.2%, to $4.9million as of September 30, 2005 compared with $4.0 million as of December 31,2004. The increase was primarily a result of the decrease in the allowance fordoubtful accounts as we recovered some accounts that were fully reserved andsome accounts improved in aging that led to a decrease in the allowance.

 

Net inventories decreased $0.9 million, or 5.2% to $15.6 million as of September 30,2005 compared with $16.5 million as of December 31, 2004, primarily due toa $765,000 inventory valuation adjustment.

 

Net cash provided by investing activities of $9.4 million for the ninemonth period ended September 30, 2005 included the sale of investmentstotaling $17.0 million, and proceeds from assets held for sale of $1.3 millionpartially offset by purchases of investments of $7.8 million and purchases ofproperty, plant and equipment, net of $1.7 million.

 

We do not have any plans to initiate any major new capital spendingprojects through 2005. We are currently completing certain projects at ourChina facilities and closing our remaining manufacturing facilities in Fremont,California. We expect to invest approximately $0.2 million in capital projectsfor the remainder of 2005. We believe that our existing and planned facilitiesand equipment are sufficient to fulfill current and expected future orders.

 

Net cash used in financing activities of $636,000 for the nine monthperiod ended September 30, 2005 consisted of payments of $450,000 relatedto long-term borrowings and $246,000 to repurchase our common stock, partiallyoffset by proceeds of $60,000 through our employee stock purchase and stockoption programs.

 

We have considered investments in other jointventures, including a new joint venture investment in China for agermanium business opportunity.  We arein the final negotiations process in forming this joint venture, and we may,upon the fulfillment of certain conditions, invest up to $2.5 million in thenew joint venture by mid-2006.

 

Our main Fremont, California manufacturing facility is financed bylong-term borrowings, which were refinanced by taxable variable rate revenuebonds in 1998. These bonds mature in 2023 and bear interest at a variable ratethat was 3.93% as of September 30, 2005. The bonds are traded in thepublic market. Repayment of principal and interest under the bonds is supportedby a letter of credit from our bank and is paid on a quarterly basis. We havethe option to redeem the bonds in whole or in part during their term. As of September 30,2005, $7.6 million was outstanding under these bonds.

 

As of September 30, 2005, the credit facility maintained byus with a bank included a letter of credit supporting repayment of ourindustrial bonds with an outstanding amount of $7.6 million. We have pledgedand placed certain investment securities with an affiliate of the bank asadditional collateral for this facility.

 

We believe that we have adequate cash and investments to meet our needsover the next 12 months. If our performance fails to improve, we will continueto use cash and may at some time be forced to seek additional capital. Therecan be no assurance that such additional capital will be available or, ifavailable it will be at terms acceptable to us. Cash from operations could beaffected by various risks and uncertainties, including, but not limited tothose set forth below under “Risks Related to Our Business.”

 

Outstanding contractual obligations as of September 30, 2005 aresummarized as follows (in thousands):

 
| ** **                  | ** ** | **Payments due by period** | ** ** |
|-----------------------------|------------|----------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1 - 3  years** | ** ** | **3 - 5  years** | ** ** | **More than  5 years** | ** ** |
| Long-term  debt             |       | $                          | 7,600      |   | $ | 450 |   | $ | 1,420 |   | $ | 900 |   | $ | 4,830 |   |
| Operating  leases           |       | 5,816                      |       | 1,095 |   | 2,051 |   | 1,519 |   | 1,151 |   |
| Total                       |       | $                          | 13,416     |   | $ | 1,545 |   | $ | 3,471 |   | $ | 2,419 |   | $ | 5,981 |   |

 

We lease certain office space, manufacturing facilities and propertyunder long-term operating leases expiring at various dates through March 2013.Total rent payments under these operating leases were approximately $1.0 millionand $1.1 million for the nine month periods ended September 30, 2005 and2004, respectively.

 

**RecentAccounting Pronouncements**

 

InNovember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 151 (“SFAS 151”), *InventoryCosts*,*an amendment of ARB No. 43,Chapter 4.* SFAS 151 amends the guidance in ARB No. 43, Chapter4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idlefacility expense, freight, handling costs, and wasted material (spoilage).Paragraph 5 of ARB 43, Chapter 4, previously stated that “...under somecircumstances, items such as idle facility expense, excessive spoilage, doublefreight, and rehandling costs may be so abnormal as to require treatment ascurrent period charges....” SFAS 151 requires that those items be recognized ascurrent period charges regardless of whether they meet the criterion of “soabnormal.” In addition, SFAS 151 requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities. The provisions of SFAS 151 are effective for inventorycosts incurred during fiscal years beginning after June 15, 2005. The 

 

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adoptionof SFAS 151 is not expected to have a material effect on our consolidatedfinancial position, results of operations or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 153 (“SFAS 153”), *“Exchanges of Nonmonetary Assets—An Amendment of APBOpinion No. 29, Accounting for Nonmonetary Transactions.”*SFAS 153 eliminates the exception from fair value measurement fornonmonetary exchanges of similar productive assets in paragraph 21(b) ofAPB Opinion No. 29, “Accounting for Nonmonetary Transactions,” andreplaces it with an exception for exchanges that do not have commercialsubstance. SFAS 153 specifies that a nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. SFAS 153 is effective for thefiscal periods beginning after June 15, 2005. We do not expect theadoption of SFAS 153 to have a material impact on our consolidatedfinancial position, results of operations or cash flows.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004) (“SFAS 123R”), *“Share-Based Payment,”* which requirescompanies to measure and recognize compensation expense for all stock-basedpayments at fair value. SFAS 123R was originally effective for all interimperiods beginning after June 15, 2005. Early adoption is encouraged andretroactive application of the provisions of SFAS 123R to the beginningof the fiscal year that includes the effective date is permitted, but notrequired.

 

In March 2005, the U.S.Securities and Exchange Commission (“ SEC”), released Staff Accounting BulletinNo. 107 (“SAB107”), *“Share-BasedPayments”* . The interpretations in SAB 107 express views of the SECstaff, regarding the interaction between SFAS 123R and certain SEC rules andregulations, and provide the staff’s views regarding the valuation ofshare-based payment arrangements for public companies. In particular, SAB 107provides guidance related to share-based payment transactions withnonemployees, the transition from nonpublic to public entity status, valuationmethods (including assumptions such as expected volatility and expected term),the accounting for certain redeemable financial instruments issued undershare-based payment arrangements, the classification of compensation expense,non-GAAP financial measures, first-time adoption of SFAS 123R in an interimperiod, capitalization of compensation cost related to share-based paymentarrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS 123R, the modification of employee shareoptions prior to adoption of SFAS 123R and disclosures in Management’sDiscussion and Analysis subsequent to adoption of SFAS 123R.

 

In April 2005, the SECapproved a new rule that delays the effective date of SFAS 123R to thefirst annual or interim reporting period for fiscal years beginning on or afterJune 15, 2005.  SFAS123R will beeffective for us beginning with the first quarter of fiscal 2006.  We are currently evaluating the impact ofSFAS 123R on our consolidated financial position and results ofoperations. See Note 3. *Accounting for Stock-Based Compensation* forinformation related to the pro forma effects on our reported net loss and netloss per share when applying the fair value recognition provisions of theprevious SFAS No. 123, *“Accountingfor Stock-Based Compensation,”* to stock-based employee compensation.

 

In May 2005,the FASB issued SFAS No. 154 (“SFAS 154”), “*AccountingChanges and Error Corrections*”, which will require entities thatvoluntarily make a change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS 154 supersedes APB No. 20 (“APB 20”), AccountingChanges, which previously required that most voluntary changes in accountingprinciple be recognized by including in the current period’s net income thecumulative effect of changing to the new accounting principle. SFAS 154 alsomakes a distinction between “retrospective application” of an accountingprinciple and the “restatement” of financial statements to reflect thecorrection of an error. Another significant change in practice under SFAS 154will be that if an entity changes its method of depreciation, amortization, ordepletion for long-lived, non-financial assets, the change must be accountedfor as a change in accounting estimate. Under APB 20, such a change would havebeen reported as a change in accounting principle. SFAS 154 applies toaccounting changes and error corrections that are made in fiscal yearsbeginning after December 15, 2005. We do not anticipate a material impactfrom the adoption of SFAS 154 on our consolidated financial position, resultsof operations, or cash flows.

 

**RisksRelated to Our Business**

** **

***Wemay incur claims or other liabilities or obligations related to our failure tofollow requirements for testing of products and provision of testing data andinformation relating to customer requirements. Additionally, customers maycancel or reduce future shipments in response to these failures, or requirere-qualifications.***

*** ***

Duringthe first quarter of 2004, we determined that we had not followed requirementsfor testing of products and provision of testing data and information relatingto customer requirements. We notified affected customers concerning ourfindings, however, there can be no assurance that we will not incur customerclaims or other liabilities or obligations in connection with this matter, nor,if we receive any such claims, that we will not have to restate results fromprior 

 

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periods.In addition, revenue in future periods may be adversely impacted if customersdecide not to order from us as a result of this disclosure. We experiencedseveral cancellations of future orders by customers pending further informationregarding enhancements to our product testing and quality control systems. Inaddition, some customers are requiring additional qualification of our Chinaoperations before placing future orders with us. We cannot be sure that we willnot receive additional cancellations of orders by other customers, or fail towin expected future orders from customers, as a result of our disclosure of ourinvestigation conclusions, or that our customers will qualify our Chinaoperations and place future orders with us.

 

***Ouroperating results depend in large part on further customer acceptance of ourexisting substrate products manufactured in China.***

*** ***

Aswe are now manufacturing only in China, if the shift of our substratemanufacturing operations to China is to be successful, we will need ourcustomers to qualify products manufactured in China. If we are unable toachieve qualifications for these products, our China facility will beunderutilized, our investments in China will not be recouped and we will beunable to lower our costs by moving to China. We may lose sales of our productsto competitors who are not manufacturing in China, or whose operations in Chinahave already been qualified by customers. If customers do not fully qualify ourChina production, we may lose additional customers and fail to achieve revenuegrowth.

 

Furthermore,some customers have reduced their orders from us until our surface quality isas good and consistent as that offered by competitors. As a result, somecustomers are now allocating their requirements for compound semiconductorsubstrates across more competitors and we believe that we have lost revenue andmarket share as a result of these customer decisions, which we may be unable torecover. If we are unable to retain our market share, our revenue andperformance will decline.

 

***Defectsin our products could diminish demand for our products.***

*** ***

Ourproducts are complex and may contain defects. We have experienced qualitycontrol problems with some of our products which caused customers to returnproducts to us, reduce orders for our products, or both. We believe that wecontinue to experience a reduction in orders as a result of our product qualityproblems. If we continue to experience quality control problems, or experiencethese or other problems in new products, customers may cancel or reduce ordersor purchase products from our competitors and sales of our products coulddecline. Defects in our products could cause us to incur higher manufacturingcosts and suffer product returns and additional service expenses, all of whichcould adversely impact our operating results.

 

Ifnew products developed by us contain defects when released, our customers maybe dissatisfied and we may suffer negative publicity or customer claims againstus, lose sales or experience delays in market acceptance of our new products.

 

***Ifwe fail to comply with environmental and safety regulations, we may be subjectto significant fines or cessation of our operations; in addition, we could besubject to suits for personal injuries caused by hazardous materials.***

*** ***

Weare subject to federal, state and local environmental and safety laws andregulations in all of our operating locations, including laws and regulationsof China. These laws, rules and regulations govern the use, storage,discharge and disposal of hazardous chemicals during manufacturing, researchand development, and sales demonstrations. If we fail to comply with applicableregulations, we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or cessation of our operations. In March 2001,we settled a claim made by the California Occupational Safety and HealthAdministration, or Cal-OSHA, in an investigation primarily regardingimpermissible levels of potentially hazardous materials in certain areas of ourmanufacturing facility in Fremont, California for $200,415, and during 2004 wewere the target of press allegations and correspondence purportedly on behalfof current and/or former employees concerning our environmental complianceprograms and exposure of our employees to hazardous materials.  In June 2005, a complaint was filedagainst us and a current and former officer, alleging personal injury, generalnegligence, intentional tort, wage loss and other damages, including punitivedamages, as a result of exposure of defendants, who are former employees ofAXT, including a minor child in utero, to high levels of gallium arsenide ingallium arsenide wafers, and methanol. There is a possibility that other current and/or former employees maybring additional litigation against us. Although we have put in placeengineering, administrative and personnel protective equipment programs toaddress these issues, our ability to expand or continue to operate our presentlocations could be restricted or we could be required to acquire costlyremediation equipment or incur other significant expenses. Existing or futurechanges in laws or regulations in the United States and China may require us toincur significant expenditures or liabilities, or may restrict our operations.In addition, our employees could be exposed to chemicals or other hazardousmaterials at our facilities and we may be subject to lawsuits seeking damagesfor wrongful death or personal injuries allegedly caused by exposure tochemicals or hazardous materials at our facilities.

 

Litigationis inherently uncertain and while we would expect to defend ourselvesvigorously, it is possible that our business, financial condition, results ofoperations or cash flows could be affected in any particular period by such litigationnow pending, and any additional litigation if brought against us.

 

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***Existingor future litigation could result in significant judgments against us, or causeus to incur costly settlements.***

*** ***

***In June 2005, a complaint was filedagainst us and a current and former officer, alleging personal injury, generalnegligence, intentional tort, wage loss and other damages, including punitivedamages, as a result of exposure of defendants, who are former employees ofAXT, including a minor child in utero, to high levels of gallium arsenide ingallium arsenide wafers, and methanol. In addition, we are defendants in an ongoing securities litigation matter.  Litigation is inherently uncertain and whilewe would expect to defend ourselves vigorously, it is possible that ourbusiness, financial condition, results of operations or cash flows could beaffected in any particular period by such litigation now pending, and anyadditional litigation if brought against us. In addition, response to such litigation could divert management’sattention from our business and operations, causing our business and financialresults to suffer.  We could incurdefense or settlement costs in excess of the insurance covering such litigationmatters, or such litigation could result in significant judgments against us,in excess of our insurance limits.***

*** ***

***Decreasesin average selling prices of our products may reduce gross margins.***

*** ***

Themarket for compound semiconductor substrates is characterized by pressures onaverage selling prices resulting from factors such as increased competition orovercapacity. We have experienced and expect to continue to experience pricepressures on our products, and if average selling prices decline in the future,our revenues and gross margins could decline. We may be unable to reduce thecost of our products sufficiently to counter the effect of lower selling pricesand allow us to keep pace with competitive pricing pressures and our marginscould be adversely affected.

 

***Theloss of one or more of our key substrate customers would significantly hurt ouroperating results.***

*** ***

Asmall number of substrate customers have historically accounted for a substantialportion of our total revenue. Our top five customers represented 35.6% and33.8% of revenue for the nine month periods ended September 30, 2005, and2004, respectively. We expect that a significant portion of our future revenuewill continue to be derived from a limited number of substrate customers. Ourcustomers are not obligated to purchase a specified quantity of our products orto provide us with binding forecasts of product purchases. In addition, ourcustomers may reduce, delay or cancel orders at any time without anysignificant penalty, and during the past year, we have experienced slowerbookings, significant push outs and cancellation of orders from some customers.In addition, several of our previously large customers have stopped operationsentirely. If we lose a major customer or if a customer cancels, reduces ordelays orders, our revenue would decline. In addition, customers that haveaccounted for significant revenue in the past may not continue to generaterevenue for us in any future period. Any delay in scheduled shipments of ourproducts could cause revenue to fall below our expectations and theexpectations of market analysts or investors, causing our stock price todecline.

 

***ProblemsIncurred by Our Joint Ventures or Venture Partners Could Result in a MaterialAdverse Impact on Our Financial Condition or Results of Operations***

*** ***

Wehave invested in five joint venture operations in China that produce productsincluding 99.99% pure gallium (4N Ga), high purity gallium, arsenic, germanium,germanium dioxide, paralytic boron nitride (pBN) crucibles, and boron oxide. Wepurchase the materials produced by these ventures for our use and sell otherportions of their production to third parties. Our ownership interest in theseentities ranges from 25 percent to 88 percent. We consolidate the threeventures in which we own a majority interest and employ equity accounting forthe two joint ventures in which we have a 25 percent interest. Several of theseventures occupy facilities within larger facilities owned and/or operated byone of the other venture partners. Several of these venture partners areengaged in other manufacturing activities at or near the same facility. In somefacilities, we share access to certain functions, including water, treatment ofhazardous waste or air quality treatment. If any of our joint venture partnersin any of these five ventures experience problems with their operations,disruptions of our joint venture operations could result, having a materialadverse effect on the financial condition and results of operation of our jointventures, and correspondingly on our financial condition or results ofoperations.

 

Inaddition, if any of our joint ventures or venture partners with whom our jointventures share facilities are deemed to have violated applicable laws, rules orregulations governing the use, storage, discharge or disposal of hazardouschemicals during manufacturing, research and development, or salesdemonstrations, the operations of our joint ventures could be adverselyaffected and we could be subject to substantial liability for clean-up efforts,personal injury and fines or suspension or cessation of our joint ventureoperations as a result of the actions of the joint ventures or other venturepartners. Employees working at the operations of our joint ventures or theoperations of any of the other venture partners could bring litigation againstus as a result of actions taken at the joint venture or venture partnerfacilities, even though we are not directly controlling the operations,including actions for exposure to chemicals or other hazardous materials at thefacilities of our joint ventures or the facilities of any venture partner thatare shared by our joint ventures. If litigation is brought against us,litigation is inherently uncertain and while we would expect to defendourselves vigorously, it is possible that our business, financial condition,results of operations or cash flows could be affected in any particular periodby such litigation if brought against us, particularly if, as a non-Chinesecompany, litigation with us is deemed 

 

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advantageous.Even if we are not deemed responsible for the actions of the joint ventures orventure partners, litigation could be costly, time consuming to defend anddivert management attention; in addition, pursuit of us could occur if we aredeemed to be the most financially viable of the partners.

 

Goingforward, we believe that investing in additional joint ventures will beimportant to remaining competitive in our marketplace and ensuring a supply ofcritical raw materials. However, we may not be able to identify complementaryjoint venture opportunities or, even once opportunities are identified, we maynot be able to reach agreement on the terms of the venture with the otherventure partners. Additional joint ventures could cause us to incur contingentliabilities or other expenses, any of which could adversely affect ourfinancial condition and operating results.

 

Sinceall of our joint venture activity is expected to occur in China, theseactivities could subject us to a number of risks associated with conductingoperations internationally, including:

 

•        Difficultiesin managing geographically disparate operations;

 

•        Difficultiesin enforcing agreements through non-U.S. legal systems;

 

•        Unexpectedchanges in regulatory requirements that may limit our ability to export theventure products or sell into particular jurisdictions or impose multipleconflicting tax laws and regulations;

 

•        Politicaland economic instability, civil unrest or war;

 

•        Terroristactivities that impact international commerce;

 

•        Difficultiesin protecting our intellectual property rights, particularly in countries wherethe laws and practices do not protect proprietary rights to as great an extentas do the laws and practices of the United States;

 

•        Changinglaws and policies affecting economic liberalization, foreign investment,currency convertibility or exchange rates, taxation or employment; and

 

•        Nationalizationof foreign owned assets, including intellectual property.

 

***Intellectualproperty infringement claims may be costly to resolve and could divertmanagement attention.***

*** ***

Othercompanies may hold or obtain patents on inventions or may otherwise claimproprietary rights to technology necessary to our business. The markets inwhich we compete are comprised of competitors who in some cases holdsubstantial patent portfolios covering aspects of products that could besimilar to ours. We could become subject to claims that we are infringingpatent, trademark, copyright or other proprietary rights of others. Forexample, we have previously been involved in two separate lawsuits allegingpatent infringement.

 

OnJune 11, 2003, Cree, Inc. filed a complaint in the United StatesCourt for Northern District of California against us alleging patentinfringement. The complaint sought damages and injunction against infringement.On July 23, 2003, we filed a counter complaint in the United States Courtfor Northern District of California, denying any patent infringement andalleging that Cree’s actions were intentionally designed to interfere with ourprospective business relationships. We reached an agreement with Cree resolvingthe disputes between us and signed a settlement agreement on March 5,2004. The resolution of the disputes did not have a material adverse impact onour condensed consolidated financial position or results of operations.

 

OnOctober 8, 2004, we announced that we had reached a tentative settlementof the litigation in Japan and interference actions in the United States withSumitomo Electric Industries, Ltd. (“SEI”), which includes a globalintellectual property cross-licensing agreement. AXT and SEI finalized thisagreement on December 2, 2004. Accordingly, we recorded a charge ofapproximately $1.4 million for the quarter ended September 30, 2004 inconnection with this settlement, and have made and expect to make royaltypayments on future sales of certain products. The litigation was withdrawn in January 2005and we abandoned the interference proceeding.

 

***Thesemiconductor industry is cyclical and has experienced a downturn which hasadversely impacted our operating results.***

*** ***

Ourcontinuing business depends in significant part upon manufacturers ofelectronic and opto-electronic semiconductor devices, as well as the currentand anticipated market demand for such devices and products using such devices.As a supplier to the semiconductor industry, we are subject to the businesscycles that characterize the industry. The timing, length and volatility ofthese cycles are difficult to predict. The semiconductor industry hashistorically been cyclical because of sudden changes in demand forsemiconductors, the manufacturing capacity of these semiconductors and changesin the technology employed in the semiconductors. The rate of changes indemand, including end demand, is high, and the effect of these changes upon usoccurs quickly, exacerbating the volatility of these cycles. These changes haveaffected the timing and amounts of customers’ purchases and investments in newtechnology. These industry cycles create pressure on our revenue, gross marginand net income (loss).

 

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Theindustry has in the past experienced periods of oversupply that result insignificantly reduced demand and prices for semiconductor devices andcomponents, including our products, both as a result of general economicchanges and overcapacity. When these periods occur, our operating results andfinancial condition are adversely affected, and create pressure on our revenue,gross margins and net income. Inventory buildups in telecommunications productsand slower than expected sales of computer equipment resulted in overcapacityand led to reduced sales by our customers, and therefore reduced purchases ofour products. During periods of weak demand such as those experienced over thepast years, customers typically reduce purchases, delay delivery of productsand/or cancel orders of component parts such as our products.

 

Increasedprice competition has resulted, causing pressure on our net sales, gross marginand net income. We experienced cancellations, price reductions, delays and pushouts of orders, which have resulted in reduced revenues. If the economicdownturn occurred again, further order cancellations, reductions in order sizeor delays in orders could occur and would materially adversely affect ourbusiness and results of operations. Actions to reduce our costs, such as thosewe have recently taken, may be insufficient to align our structure withprevailing business conditions. We may be required to undertake additionalcost-cutting measures, and may be unable to invest in marketing, research anddevelopment and engineering at the levels we believe are necessary to maintainour competitive position. Our failure to make these investments could seriouslyharm our business.

 

Duringperiods of increasing demand for semiconductor devices, we must have sufficientmanufacturing capacity and inventory to meet customer demand, and must be ableto attract, hire, train and retain qualified employees to meet demand. If weare unable to effectively manage our resources and production capacity duringan industry upturn, there could be a material adverse effect on our business,financial condition and results of operations.

 

***Our results ofoperations may suffer if we do not effectively manage our inventory.***

*** ***

We must manageour inventory of component parts, work-in-process, and finished goodseffectively to meet changing customer requirements, while keeping inventorycosts down and improving gross margins. Some of our products and supplies havein the past and may in the future become obsolete while in inventory due tochanging customer specifications, or become excess inventory due to decreaseddemand for our products and an inability to sell the inventory within aforeseeable period. Furthermore, if current costs of production increase orsales prices drop below the standard prices at which we value inventory, we mayneed to take a charge for a reduction in inventory values. We have in the past,including during 2004, had to take inventory valuation and impairment charges.Any future unexpected changesin demand or increases in costs of production that cause us to takeadditional charges for un-saleable, obsolete or excess inventory, or toreduce inventory values, could adversely affect our results of operations.charges.

 

***Theimpact of changes in global economic conditions on our customers may cause usto fail to meet expectations, which would negatively impact the price of ourstock.***

*** ***

Ouroperating results can vary significantly based upon the impact of changes inglobal economic conditions on our customers. The revenue growth andprofitability of our business depends on the overall demand for our substrates,and we are particularly dependant on the market conditions for the wireless,solid-state illumination, fiber optics and telecommunications industries.Because our sales are primarily to major corporate customers whose businessesfluctuate with general economic and business conditions, a softening of demandfor products that use our substrates, caused by a weakening economy may resultin decreased revenues. Customers may find themselves facing excess inventoryfrom earlier purchases, and may defer or reconsider purchasing products due tothe downturn in their business and in the general economy.

 

***Ifwe have low product yields, the shipment of our products may be delayed and ouroperating results may be adversely impacted.***

*** ***

Ourproducts are manufactured using complex technologies, and the number of usablesubstrates we can produce can fluctuate as a result of many factors, including:

 

•             impuritiesin the materials used;

 

•             contaminationof the manufacturing environment;

 

•             substratebreakage;

 

•             equipmentfailure, power outages or variations in the manufacturing process; and

 

•             performanceof personnel involved in the manufacturing process.

 

Ifour yields decrease, our revenue could decline if we are unable to produceneeded product on time while our 

 

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manufacturingcosts remain fixed, or could increase. We have experienced product shipmentdelays and difficulties in achieving acceptable yields on both new and olderproducts, and delays and poor yields have adversely affected our operatingresults. We may experience similar problems in the future and we cannot predictwhen they may occur or their severity. In particular, many of our manufacturingprocesses are new and are still being refined, which can result in loweryields.

 

***Ifwe do not successfully develop new products to respond to rapidly changingcustomer requirements, our ability to generate revenue, obtain new customers, andretain existing customers may suffer.***

*** ***

Oursuccess depends on our ability to offer new products and product features thatincorporate leading technology and respond to technological advances. Inaddition, our new products must meet customer needs and compete effectively onquality, price and performance. The life cycles of our products are difficultto predict because the markets for our products are characterized by rapidtechnological change, changing customer needs and evolving industry standards. Ifour competitors introduce products employing new technologies or performancecharacteristics, our existing products could become obsolete and unmarketable.During the past two years, we have seen our competitors selling more substratesmanufactured using a crystal growth technology similar to ours, which haseroded our technological differentiation. Other companies, including Triquent,are actively developing substrate materials that could be used to manufacturedevices that could provide the same high-performance, low-power capabilities asGaAs- and InP-based devices at competitive prices. If these substrate materialsor VGF-derived products are successfully developed and semiconductor devicemanufacturers adopt them, demand for our GaAs substrates could decline and ourrevenue could suffer.

 

Thedevelopment of new products can be a highly complex process, and we mayexperience delays in developing and introducing new products. Any significantdelays could cause us to fail to timely introduce and gain market acceptance ofnew products. Further, the costs involved in researching, developing andengineering new products could be greater than anticipated. If we fail to offernew products or product enhancements or fail to achieve higher qualityproducts, we may not generate sufficient revenue to offset our developmentcosts and other expenses or meet our customers’ requirements.

 

***Intensecompetition in the markets for our products could prevent us from increasingrevenue and sustaining profitability.***

*** ***

Themarkets for our products are intensely competitive. We face competition for oursubstrate products from other manufacturers of substrates, such as Freiberger,Hitachi Cable, Japan Energy and Sumitomo Electric and from semiconductor devicemanufacturers that produce substrates for their own use, and from companies,such as Triquent, that are actively developing alternative materials to GaAsand some semiconductor devices are being marketed using these materials. Webelieve that at least two of our competitors are shipping high volumes of GaAssubstrates manufactured using a technique similar to our VGF technique. Othercompetitors may develop and begin using similar technology. If we are unable tocompete effectively, our revenue may not increase and we may be unable to beprofitable. We face many competitors that have a number of significantadvantages over us, including:

 

•             greaterexperience in the business;

 

•             moremanufacturing experience;

 

•             extensiveintellectual property;

 

•             broader namerecognition; and

 

•             significantlygreater financial, technical and marketing resources.

 

Ourcompetitors could develop new or enhanced products that are more effective thanour products are.

 

Thelevel and intensity of competition has increased over the past year and weexpect competition to continue to increase in the future. Competitive pressurescaused by the current economic conditions have resulted in reductions in theprices of our products, and continued or increased competition could reduce ourmarket share, require us to further reduce the prices of our products, affectour ability to recover costs or result in reduced gross margins.

 

***Demandfor our products may decrease if our customers experience difficultymanufacturing, marketing or selling their products.***

*** ***

Ourproducts are used as components in our customers’ products. Accordingly, demandfor our products is subject to factors affecting the ability of our customersto successfully introduce and market their products, including:

 

•             thecompetition our customers face in their particular industries;

 

•             thetechnical, manufacturing, sales and marketing and management capabilities ofour customers;

 

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•             thefinancial and other resources of our customers; and

 

•             the inabilityof our customers to sell their products if they infringe third partyintellectual property rights.

 

Ifdemand for the end user applications for which our products are used decreases,or our customers are unable to develop, market and sell their products, demandfor our products will decrease.

 

***Thefinancial condition of our customers may affect their ability to pay amountsowed to us.***

*** ***

Manyof our customers are facing business downturns that have reduced their cashbalances and their prospects. We frequently allow our customers to pay forproducts we ship to them within 30 to 120 days after delivery. Subsequent toour shipping a product, some customers have been unable to make payments asdue, reducing our cash balances and causing us to incur charges to allow for apossibility that some accounts might not be paid. During 2004, a customer ofone agent filed for bankruptcy protection. We incurred a charge equal to theamount owed us and believe that there is a substantial likelihood that we willbe able to recoup little, if any, of the this amount. Other customers may alsobe forced to file for bankruptcy. If our customers do not pay their accountswhen due, we will be required to incur charges that would reduce our earnings.

 

***Wepurchase critical raw materials and parts for our equipment from single orlimited sources, and could lose sales if these sources fail to fill our needs.***

*** ***

Wedepend on a limited number of suppliers for certain raw materials, componentsand equipment used in manufacturing our products, including key materials suchas quartz tubing, polishing solutions, and paralytic boron nitride. Althoughseveral of these raw materials are purchased from suppliers in whom we hold anownership interest, we generally purchase these materials through standardpurchase orders and not pursuant to long-term supply contracts and no supplierguarantees supply of raw materials or equipment to us. If we lose any of ourkey suppliers, our manufacturing efforts could be significantly hampered and wecould be prevented from timely producing and delivering products to ourcustomers. We have in the past experienced delays obtaining critical rawmaterials and spare parts, including gallium, due to shortages of thesematerials. Although we hope to alleviate some of these delays and shortages asa result of our interests in our joint ventures, we may experience delays dueto shortages of materials and may be unable to obtain an adequate supply ofmaterials. These shortages and delays could result in higher materials costsand cause us to delay or reduce production of our products. If we have to delayor reduce production, we could fail to meet customer delivery schedules and ourrevenue and operating results could suffer.

 

***Wehave made and may continue to make strategic investments in raw materialssuppliers, which may not be successful and may result in the loss of all orpart of our investment.***

*** ***

Wehave made investments through our five joint ventures in raw material suppliersin China, that provide us with opportunities to gain supply of key rawmaterials that are important to our substrate business. These affiliates eachhave a market beyond that provided by us. We do not have influence over all ofthese companies, each of which is located in China, and in some we have madeonly a strategic, minority investment. We may not be successful in achievingthe financial, technological or commercial advantage upon which any giveninvestment is premised, and we could end up losing all or part of ourinvestment.

 

***Oursubstrate products have a long qualification cycle that makes it difficult toplan our expenses and forecast our results.***

*** ***

Customerstypically place orders with us for our substrate products three months to ayear or more after our initial contact with them. The sale of our products maybe subject to delays due to our customers’ lengthy internal budgeting, approvaland evaluation processes. During this time, we may incur substantial expensesand expend sales, marketing and management efforts while the customers evaluateour products. These expenditures may not result in sales of our products. If wedo not achieve anticipated sales in a period as expected, we may experience anunplanned shortfall in our revenue. As a result, we may not be able to coverexpenses, causing our operating results to vary. In addition, if a customerdecides not to incorporate our products into its initial design, we may nothave another opportunity to sell products to this customer for many months oreven years. In the current competitive and economic climate, the average salescycle for our products has lengthened even further and is expected to continueto make it difficult to accurately forecast our future sales. We anticipatethat sales of any future substrate products will also have lengthy sales cyclesand will, therefore, be subject to risks substantially similar to thoseinherent in the lengthy sales cycle of our current substrate products.

 

***Ifwe are unable to protect our intellectual property, we may lose valuable assetsor incur costly litigation.***

*** ***

Werely on a combination of patents, copyrights, trademark and trade secret laws,non-disclosure agreements and other intellectual property protection methods toprotect our proprietary technology. However, we believe that, due to the rapidpace of technological innovation in the markets for our products, our abilityto establish and maintain a position of technology leadership also depends onthe skills of our development personnel.

 

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Despiteour efforts to protect our intellectual property, a third party could developproducts or processes similar to ours. Our means of protecting our proprietaryrights may not be adequate and our competitors may independently developsimilar technology, duplicate our products or design around our patents. Webelieve that at least two of our competitors have begun to ship GaAs substratesproduced using a process similar to our VGF technique. Our competitors may alsodevelop and patent improvements to the VGF technology upon which we rely, andthus may limit any exclusivity we enjoy by virtue of our patents or tradesecrets.

 

Itis possible that pending or future United States or foreign patent applicationsmade by us will not be approved, that our issued patents will not protect ourintellectual property, or that third parties will challenge the ownershiprights or the validity of our patents. In addition, the laws of some foreigncountries may not protect our proprietary rights to as great an extent as dothe laws of the United States and it may be more difficult to monitor the useof our intellectual property. Our competitors may be able to legitimatelyascertain non-patented proprietary technology embedded in our systems. If thisoccurs, we may not be able to prevent the development of technologysubstantially similar to ours.

 

Wemay have to resort to costly litigation to enforce our intellectual propertyrights, to protect our trade secrets or know-how or to determine their scope,validity or enforceability. Enforcing or defending our proprietary technologyis expensive, could cause us to divert resources and may not prove successful.Our protective measures may prove inadequate to protect our proprietary rights,and if we fail to enforce or protect our rights, we could lose valuable assets.

 

Forexample, we have recently been involved in litigation with Sumitomo ElectricIndustries, Ltd. (“SEI”) in Japan as well as interference actions in the UnitedStates. We and SEI approved a settlement of this litigation during the fourthquarter of 2004 and the litigation was withdrawn and we abandoned theinterference proceeding. We incurred an initial charge of approximately $1.4million and will have to pay ongoing royalties to SEI on certain of ourproducts.

 

***Wederive a significant portion of our revenue from international sales, and ourability to sustain and increase our international sales involves significantrisks.***

*** ***

Ourrevenue growth depends in part on the expansion of our international sales andoperations. International sales represented 80% and 78% of our total revenuefor the nine month periods ended September 30, 2005 and 2004,respectively. We expect that sales to customers outside the U.S. will continueto represent a significant portion of our revenue, particularly sales tocustomers in Asia.

 

Currently,an increasing percentage of our sales are to customers headquartered in Asia.Certain manufacturing facilities and suppliers are also located outside theU.S. Managing our global operations presents challenges, including periodicregional economic downturns, trade balance issues, varying business conditionsand demands, political instability, variations in enforcement of intellectualproperty and contract rights in different jurisdictions, differences in the abilityto develop relationships with suppliers and other local businesses, changes inU.S. and international laws and regulations including U.S. exportrestrictions, fluctuations in interest and currency exchange rates, the abilityto provide sufficient levels of technical support in different locations,cultural differences, shipping delays and terrorist acts or acts of war, amongother risks. Many of these challenges are present in China, which represents alarge potential market for semiconductor equipment and where we anticipatesignificant opportunity for growth. Global uncertainties with respect to: (i) economicgrowth rates in various countries; (ii) sustainability of demand forelectronics products; (iii) capital spending by semiconductor manufacturers;(iv) price weakness for certain semiconductor devices; and (v) politicalinstability in regions where we have operations may also affect our business,financial condition and results of operations.

 

Ourdependence on international sales involves a number of risks, including:

 

•             changes intariffs, import or export restrictions and other trade barriers;

 

•             unexpectedchanges in regulatory requirements;

 

•             longerperiods to collect accounts receivable;

 

•             changes inexport license requirements;

 

•             politicaland economic instability;

 

•             unexpectedchanges in diplomatic and trade relationships; and

 

•             foreignexchange rate fluctuations.

 

Oursales are denominated in U.S. dollars, except for sales to our Japanese andsome Taiwanese customers, which are denominated in Japanese yen. Thus,increases in the value of the U.S. dollar could increase the price of ourproducts in non-U.S. markets and make our products more expensive thancompetitors’ products in these markets. 

 

36

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Also, denominating some sales in Japanese yen subjects us tofluctuations in the exchange rates between the U.S. dollar and the Japaneseyen. The functional currencies of our Chinese subsidiaries are the localcurrencies. We incur transaction gains or losses resulting from consolidationof expenses incurred in local currencies for these subsidiaries, as well as intranslation of the assets and liabilities of these assets at each balance sheetdate. If we do not effectively manage the risks associated with internationalsales, our revenue, cash flows and financial condition could be adverselyaffected.

 

***Becauseof power shortages in China, we may have to temporarily close our Chinaoperations, which would adversely impact our ability to manufacture ourproducts, meet customer orders, and result in reduced revenues.***

*** ***

TheChinese government faced a power crunch over the summer of 2004 and reportedthat power demand in 24 provinces outstripped supply in peak periods during thefirst four months of 2004. Instability in electrical supply caused sporadicoutages among residential and commercial consumers. As a result, the Chinesegovernment implemented tough measures in 2004 to ease the energy shortage.Provinces imposed power brownouts during 2004 to reduce electricity demand andsome companies in Beijing were ordered to give their employees a week off toease the pressure on power supply. The plants, most of which are state-owned,were closed and reopened on a staggered schedule to reduce power consumptionduring the capital’s hottest months during 2004. As a result we closed most ofour operations for a week in late July 2004 in conformance with thispolicy. Although shortages requiring closure of facilities did not occurduring summer 2005, if we are required to make additional temporary closures ofour Beijing and joint venture operations at any time during the remainder of2005, we may be unable to manufacture our products, and would then be unable tomeet customer orders except from inventory on hand. As a result, we could losesales, adversely impacting our revenues, and our relationships with ourcustomers could suffer, impacting our ability to generate future sales. Inaddition, if power is shut off at our Beijing operations at any time, either voluntarilyor as a result of unplanned brownouts, during certain phases of ourmanufacturing process including our crystal growth phase, the work in processmay be ruined and rendered unusable, causing us to incur expense that will notbe covered by revenue, and negatively impacting our cost of goods sold andgross margins. We are attempting to partially mitigate the potential effects ofpower outages by building inventory in anticipation of power outages during thesummer. This inventory build is prepared to accommodate forecast demand ratherspecific customer orders. If the inventory we build is not ordered bycustomers, we may have to scrap these products and incur a cost which willreduce our gross margins.

 

***Weneed to continue to improve or implement our systems, procedures and controlsand may not receive a favorable attestation report on our internal controlsystems by our independent registered public accounting firm.***

*** ***

Therequirements adopted by the Securities and Exchange Commission in response tothe passage of the Sarbanes-Oxley Act of 2002 will require annual review andevaluation of our internal control systems, and an attestation of these systemsby our independent registered public accounting firm beginning with our fiscalyear ending December 31, 2007. This may be due earlier beginning with ourfiscal year ending December 31, 2006 if our market capitalizationincreases above $75 million on the determining date on June 30, 2006. Weare currently reviewing our internal control procedures and considering furtherdocumentation of such procedures that may be necessary. We are currentlyevaluating the extent to which any of our joint ventures may also be requiredto comply, if at all.  We can give noassurances that our systems will satisfy the new requirements of the Securitiesand Exchange Commission, or if required, that any of the systems of our jointventures will meet such requirements, or that we will receive a favorablereview and attestation by our independent registered public accounting firm.

 

Inaddition, the shift of our manufacturing operations to China has placed andcontinues to place a significant strain on our operations and managementresources. We have upgraded our inventory control systems and may implementadditional systems relating to consolidation of our financial results, butcontinue to rely on certain manual processes in our operations and inconnection with consolidation of our financial results. If we fail to managethese changes effectively, our operations may be disrupted.

 

Tomanage our business effectively, we may need to implement additional andimproved management information systems, further develop our operating,administrative, financial and accounting systems and controls, add experiencedsenior level managers, and maintain close coordination among our executive,engineering, accounting, marketing, sales and operations organizations.

 

***Legislativeactions, higher insurance costs and potential new accounting pronouncements arelikely to cause our general and administrative expenses to increase and impactour future financial position and results of operations.***

*** ***

Inorder to comply with rules and regulations adopted pursuant to theSarbanes-Oxley Act of 2002 by the SEC, as well as changes to listing standardsadopted by NASDAQ, and accounting changes adopted affecting accounting forstock-based compensation we may be required to increase our internal controls,hire additional personnel and additional outside legal, accounting and advisoryservices, all of which will cause our general and administrative costs toincrease. Insurers may increase premiums as a result of the high claims ratesthey incurred over the past year. Changes in the accounting rules, includinglegislative and other rules to account for employee stock options as acompensation expense among others, could materially increase the expense thatwe report under generally accepted accounting principles and adversely affectour operating results.

 

37

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***Ifwe fail to manage periodic contractions, we may utilize our cash balances andour existing cash and cash equivalent balances could decline.***

*** ***

Weanticipate that our existing cash resources will fund any anticipated operatinglosses, purchases of capital equipment and provide adequate working capital forthe next twelve months. However, our liquidity is affected by many factorsincluding, among others, the extent to which we pursue additional capitalexpenditures, the level of our production, and other factors related to theuncertainties of the industry and global economies. If we fail to manage ourcontractions successfully we may draw down our cash reserves, which wouldadversely affect our operating results and financial condition, reduce ourvalue and may impinge our ability to raise debt and equity funding in thefuture, at a time when we may be required to raise additional cash.Accordingly, there can be no assurance that events in the future will notrequire us to seek additional capital, or, if so required, that such capitalwill be available on terms acceptable to us, if at all. As part of our effortto reduce costs, we may lose key staff, production resources, and technologythat we will need to grow when end markets recover. These events could reduceour ability to grow profitably as markets recover.

 

Weanticipate that our existing cash resources will fund any anticipated operatinglosses, purchases of capital equipment and provide adequate working capital forthe next twelve months. Our liquidity is affected by many factors including,among others, the extent to which we pursue additional capital expenditures,the level of our production efforts, and other factors related to theuncertainties of the industry and global economies. Accordingly, there can beno assurance that events in the future will not require us to seek additionalcapital sooner, or, if so required, that such capital will be available onterms acceptable to us if at all.

 

***Changesin China’s political, social and economic environment may affect our financialperformance.***

*** ***

Ourfinancial performance may be affected by changes in China’s political, socialand economic environment. The role of the Chinese central and local governmentsin the Chinese economy is significant. Chinese policies toward economicliberalization, and laws and policies affecting technology companies, foreigninvestment, currency exchange rates and other matters could change, resultingin greater restrictions on our ability to do business and operate ourmanufacturing facilities in China. Any imposition of surcharges or any increasein Chinese tax rates could hurt our operating results. The Chinese governmentcould revoke, terminate or suspend our license for national security andsimilar reasons without compensation to us. If the government of China were totake any of these actions, we would be prevented from conducting all or part ofour business. Any failure on our part to comply with governmental regulationscould result in the loss of our ability to manufacture our products in China.

 

Chinahas from time to time experienced instances of civil unrest and hostilities.Confrontations have occurred between the military and civilians. Events of thisnature could influence the Chinese economy, result in nationalization offoreign-owned operations such as ours, and could negatively affect our abilityto operate our facilities in China.

 

***We may face additional risks as a result of therevaluation of the Chinese currency.***

 

In July 2005, the People’s Republic ofChina agreed to a shift in Chinese currency policy and established a 2%revaluation of the renminbi, and the renminbi will now be referenced to a basketof currencies, with a daily trading band of +/-0.3%.  Depending on market conditions and the state of the Chinese economy, itis possible that China will make more adjustments in the future.  Over the next five to ten years, China maymove to a managed float system, with opportunistic interventions.  This reserve diversification may negativelyimpact the United States dollar and U.S. interest rates, which could in turnnegatively impact the Company’s operating results and financial condition.  A significant percentage of our sales aremade to customers located outside of the United States, particularly Asia.  Our sales are denominated in U.S.dollars, except for sales to our Japanese and some Taiwanese customers, whichare denominated in Japanese yen. Thus, increases in the value of the U.S.dollar could increase the price of our products in non-U.S. markets and makeour products more expensive than competitors’ products in these markets.  The functional currencies of our Chinesesubsidiaries, including our joint ventures, are the local currency; since mostof our operations are conducted in China, many of our costs are incurred inChinese currency, which subjects us to fluctuations in the exchange ratesbetween the U.S. dollar and the Chinese renminbi. We incur transaction gains orlosses resulting from consolidation of expenses incurred in local currenciesfor these subsidiaries, as well as in translation of the assets and liabilitiesof these assets at each balance sheet date. These risks may be increased by the fluctuation and revaluation of theChinese renminbi.  If we do noteffectively manage the risks associated with this currency risk, our revenue,cash flows and financial condition could be adversely affected.

 

***Areoccurrence of Severe Acute Respiratory Syndrome (SARS) or the outbreak of adifferent contagious diseasesuch as the Avian Flu may adversely impact ourmanufacturing operations and some of our key suppliers and customers.***

*** ***

Themajority of our substrate manufacturing activities are conducted in China. Inaddition, we source key raw materials, including gallium, from our jointventures and other suppliers in China. The 2003 SARS outbreak was most 

 

38

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notable in China and a small number of cases were reported in 2004. Oneemployee at our LED production facility in China contracted SARS in late April 2003prompting us to close the facility for ten days. There was no significantimpact to our ability to fill customer orders. If there were to be anotheroutbreak of SARS or a different contagious disease, such as Avian Flu, and ifour employees contracted the disease, we may be required to temporarily closeour manufacturing operations. Similarly, if one of our key suppliers isrequired to close for an extended period, we may not have enough raw materialinventory to continue manufacturing operations. In addition, while we possessmanagement skills among our China staff that enable us to maintain ourmanufacturing operations with minimal on-site supervision from our US-basedstaff, our business could also be harmed if travel to or from Asia and theUnited States is restricted or inadvisable, as it was during parts of 2003.None of our substrate competitors is as dependent on manufacturing facilitiesin China as we are. If our manufacturing operations were closed for asignificant period, we could lose revenue and market share during that periodwhich would depress our financial performance and could be difficult torecapture. Finally, if one of our key customers is required to close for anextended period, we may not be able to ship product to them, our revenue woulddecline and our financial performance would suffer.

 

***Theeffect of terrorist threats and actions on the general economy could decreaseour revenues.***

*** ***

TheUnited States continues to be on alert for terrorist activity. The potentialnear- and long-term impact terrorist activities may have in regards to oursuppliers, customers and markets for our products and the U.S. economy areuncertain. There may be embargos of ports or products, or destruction ofshipments or our facilities, or attacks that affect our personnel. There may beother potential adverse effects on our operating results due to a significantevent that we cannot foresee. Since we perform substantially all of ourmanufacturing operations in China, and a significant portion of our customersare located outside of the Untied States, terrorist activity or threats againstUS-owned enterprise are a particular concern to us.

 

***Ifany of our facilities is damaged by actions such as fire, explosion, or naturaldisaster, we may not be able to manufacture our products.***

*** ***

Theongoing operation of our manufacturing and production facilities in China iscritical to our ability to meet demand for our products. If we are not able touse all or a significant portion of our facilities for prolonged periods forany reason, we will not be able to manufacture products for our customers. Forexample, a natural disaster, fire or explosion caused by our use of combustiblechemicals and high temperatures during our manufacturing processes would rendersome or all of our facilities inoperable for an indefinite period of time.Actions outside of our control, such as earthquakes, could also damage ourfacilities, rendering them inoperable. If we are unable to operate ourfacilities and manufacture our products, we will lose customers and revenue andour business will be harmed.

 

***Unpredictablefluctuations in our operating results could disappoint analysts or ourinvestors, which could cause our stock price to decline.***

*** ***

Wehave not over the past year been able to sustain growth, and may not be able toreturn to historic growth levels in the current economic environment. Our netloss in 2002 was the largest in our history and our losses continued during2003, 2004, and the first three quarters of 2005.

 

Wehave and may continue to experience significant fluctuations in our revenue andearnings. Our quarterly and annual revenue and operating results have variedsignificantly in the past and may vary significantly in the future due to anumber of factors, including:

 

•             our abilityto develop, manufacture and deliver high quality products in a timely andcost-effective manner;

 

•             decline ingeneral economic conditions or downturns in the industry in which we compete;

 

•             fluctuationsin demand for our products;

 

•             expansion ofour manufacturing capacity;

 

•             expansion ofour operations in China;

 

•             limitedavailability and increased cost of raw materials;

 

•             the volumeand timing of orders from our customers, and cancellations, push outs anddelays of customer orders;

 

•             fluctuationof our manufacturing yields;

 

39

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•             decreases inthe prices of our competitors’ products;

 

•             costsincurred in connection with any future acquisitions of businesses ortechnologies; and

 

•             increases inour expenses, including expenses for research and development.

 

Dueto these factors, we believe that period-to-period comparisons of our operatingresults may not be meaningful indicators of our future performance. Ouroperating results have over the past year at times been below the expectationsof securities analysts or investors. If this occurs again in future periods,the price of our common stock could decline or fluctuate.

 

Asubstantial percentage of our operating expenses are fixed in the short termand we may be unable to adjust spending to compensate for an unexpectedshortfall in revenues. As a result, any delay in generating revenue could causeour operating results to be below the expectations of market analysts orinvestors, which could also cause our stock price to fall.

 

***Ourstock price has been and may continue to be volatile.***

*** ***

Ourstock price has fluctuated significantly since we began trading on the NASDAQNational Market. For the twelve months ended December 31, 2004, the highand low closing sales prices of our common stock were $4.68 and $1.05,respectively, and for the nine months ended September 30, 2005, the highand low closing sales prices of our common stock were $1.56 and $1.10,respectively. A number of factors could cause the price of our common stock tocontinue to fluctuate substantially, including:

 

•             actual oranticipated fluctuations in our quarterly or annual operating results;

 

•             changes inexpectations about our future financial performance or changes in financialestimates of securities analysts;

 

•             announcementsof technological innovations by us or our competitors;

 

•             new productintroduction by us or our competitors;

 

•             largecustomer orders or order cancellations; and

 

•             theoperating and stock price performance of comparable companies.

 

Inaddition, the stock market in general has experienced extreme volatility thatoften has been unrelated to the operating performance of particular companies.These broad market and industry fluctuations may adversely affect the tradingprice of our common stock, regardless of our actual operating performance.

 

***Wehave adopted certain anti-takeover measures that may make it more difficult fora third party to acquire us.***

*** ***

Ourboard of directors has the authority to issue up to 2,000,000 shares ofpreferred stock and to determine the price, rights, preferences and privilegesof those shares without any further vote or action by the stockholders. Therights of the holders of common stock will be subject to, and may be adverselyaffected by, the rights of the holders of any preferred stock that may beissued in the future. The issuance of shares of preferred stock, whilepotentially providing desirable flexibility in connection with possibleacquisitions and for other corporate purposes, could have the effect of makingit more difficult for a third party to acquire a majority of our outstandingvoting stock. We have no present intention to issue shares of preferred stock.

 

Wehave adopted a preferred stock purchase rights plan intended to guard againstcertain takeover tactics. The adoption of this plan was not in response to anyproposal to acquire us, and the board is not aware of any such effort. Theexistence of this plan could also have the effect of making it more difficultfor a third party to acquire a majority of our outstanding voting stock. Inaddition, certain provisions of our certificate of incorporation may have theeffect of delaying or preventing a change of control, which could adverselyaffect the market price of our common stock.

 

40

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Inaddition, provisions in our amended and restated certificate of incorporationand bylaws may have the effect of delaying or preventing a merger, acquisitionor change of control of us, or changes in our management, including:

 

•             the divisionof our board of directors into three separate classes, each with three yearterms;

 

•             the right ofour board to elect a director to fill a space created by a board vacancy or theexpansion of the board;

 

•             the abilityof our board to alter our bylaws;

 

•             the abilityof our board to authorize the issuance of up to 2,000,000 shares of blank checkpreferred stock; and

 

•             therequirement that only our board or the holders of at least 10% of ouroutstanding shares may call a special meeting of our stockholders.

 

Furthermore,because we are incorporated in Delaware, we are subject to the provisions of Section 203of the Delaware General Corporation Law. These provisions prohibit largestockholders, in particular those owning 15% or more of the outstanding votingstock, from consummating a merger or combination with a corporation unless:

 

•             662/3%of the shares of voting stock not owned by these large stockholders approve themerger or combination, or

 

•             the board ofdirectors approves the merger or combination or the transaction which resultedin the large stockholder owning 15% or more of our outstanding voting stock.

 

**ITEM 3*.*QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**ForeignCurrency Risk**

 

We use short-term forward exchange contracts for hedging purposes toreduce the effects of adverse foreign exchange rate movements. We havepurchased foreign exchange contracts to hedge against certain trade accountsreceivable denominated in Japanese yen. The change in the fair value of the forwardcontracts is recognized as part of the related foreign currency transactions asthey occur. As of September 30, 2005, we had no outstanding commitmentswith respect to foreign exchange contracts.

 

**InterestRate Risk**

 

Cash and cash equivalents earning interest and certain variable ratedebt instruments are subject to interest rate fluctuations. The following tablesets forth the probable impact of a 10% change in interest rates (inthousands):

 
| **Instrument**                             | ** ** | **Balance as of  September 30,  2005** | ** ** | **Current  Interest  Rate** | ** ** | **Projected Annual  Interest  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Decline  Income/(Expense)** | ** ** | **Proforma 10%  Interest Rate  Increase  Income/(Expense)** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------|------------|--------------------------------------------------|------------|-----------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| Cash                                       |       | $                                                     | 6,954      |                        | 0.50       | %                                                | $          | 35                                                              |       | $                                                                | 31         |   | $ | 38 |   |
| Cash equivalents                           |       | 7,631                                                 |       | 3.75                        |       | 286                                              |       | 257                                                             |       | 315                                                              |       |
| Investment  in debt and equity instruments |       | 17,255                                                |       | 4.48                        |       | 773                                              |       | 696                                                             |       | 850                                                              |       |
| Long-term debt                             |       | (7,600                                                | )          | 3.63                        |       | (276                                             | )          | (248                                                            | )          | (303                                                             | )          |
|                                       |       |                                                  |       |                        |       | $                                                | 818        |                                                            | $          | 736                                                              |       | $ | 900 |   |
|                                            |            |                                                       |            |                             |            |                                                  |            |                                                                 |            |                                                                  |            |  |  |  |  |

 

**EquityRisk**

 

We also maintain minority investments in private and publicly tradedcompanies. These investments are reviewed for other than temporary declines invalue on a quarterly basis. Reasons for other than temporary declines in valueinclude whether the related company would have insufficient cash flow tooperate for the next twelve months, significant changes in the operatingperformance and changes in market conditions. For the nine month period ended September 30,2005, we recorded a $1.1 million charge to write down our investment in onepublic U.S. company. As of September 30, 2005, the minority investments wecontinue to hold amounted to $3.0 million.

 

41

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**ITEM 4*.*CONTROLSAND PROCEDURES**

 

(a) Underthe supervision and with the participation of our management, our ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended. Based upon thatevaluation, our Chief Executive Officer and our Chief Financial Officerconcluded that the our disclosure controls and procedures were effective as ofthe end of the period covered by this quarterly report.

 

(b) Nochange in our internal control over financial reporting was made during thequarter ended September 30, 2005, that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

42

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**PART II OTHER INFORMATION**

 

**Item1. Legal Proceedings**

 

From time to time we may be involved in judicial or administrativeproceedings concerning matters arising in the ordinary course of business. Wedo not expect that any of these matters, individually or in the aggregate, willhave a material adverse effect on our business, financial condition, cash flowsor results of operation.

 

OnOctober 15, 2004, a purported securities class action lawsuit was filed inthe United States Court for the Northern District of California. City of HarperWoods Employees Retirement System v. AXT, Inc. et al., No. C 04 4362MJJ. The lawsuit names AXT, Inc. and our chief executive officer, Chinaoperations, as defendants, and is brought on behalf of a class of allpurchasers of our securities from February 6, 2001 through April 27,2004. The complaint alleges that we announced financial results during thisperiod that were false and misleading. No specific amount of damages isclaimed. On February 4, 2005, the Court consolidated the case with arelated case making similar allegations, and appointed a lead plaintiff, whowill file a consolidated complaint. We believe that there are meritoriousdefenses against this litigation and intends to vigorously defend it. On September 23,2005 the Court granted our motion to dismiss the complaint, with leave toamend. However, due to the inherent uncertainties of litigation, we cannotaccurately predict the ultimate outcome of the litigation. Any unfavorableoutcome of the litigation could have an adverse impact on our business,financial condition and results of operations.

 

On June 1, 2005, a lawsuit was filed in the Superior Court ofCalifornia, County of Alameda, *Zhao et. Al. vs. AmericanXtal Technology, et. al.*, No. R 605215713.  The lawsuit complaint names as defendantsAXT, its chief technology officer, its former interim chief executive officer,a former safety department employee and a supplier to AXT.  The lawsuit is brought on behalf of twoformer employees and their minor child. The complaint alleges personal injury, general negligence, intentionaltort, wage loss and other damages, including punitive damages, as a result ofexposure to the child while in utero to high levels of gallium arsenide andmethanol used in the production of gallium arsenide wafers.

 

We believe that there are meritorious defenses against this litigationand intend to vigorously defend it.  AXT’scommercial general liability insurance carrier has agreed to fund AXT’s defenseof the case, but has reserved the right to deny coverage, in whole or in part,in the future under selected policy provisions and applicable law.  There is $21 million in available limitsunder the policies in question. Due to the inherent uncertainties oflitigation, we cannot accurately predict the ultimate outcome of thelitigation. Any unfavorable outcome of the litigation could have an adverseimpact on our business, financial condition and results of operations.

 

**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

 

During the three month period ended September 30, 2005, werepurchased the following shares of our common stock:

 
| **Period**                                              | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average Price  Paid Per  Share** | ** ** | **Total Number of  Shares  Purchased as  Part of a Publicly  Announced Plan  or Program (1)** | ** ** | **Approximate  Dollar Value  of Shares That  May Yet Be  Purchased  Under the  Plan or  Program** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------|------------|------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| July 1, 2005 through July 31,  2005           |       | 10,000                                 |       | $                                  | 1.24       |                                                                                               | 10,000     |                                                                                                   | $          | 1,794,745 |   |
| August 1, 2005 through August 31,  2005       |       | 33,433                                 |       | 1.21                               |       | 33,433                                                                                             |       | 1,754,160                                                                                              |       |
| September 1, 2005 through September 30,  2005 |       | —                                 |       | —                             |       | —                                                                                             |       | —                                                                                                 |       |
| Total                                                   |       | 43,433                                 |       | $                                  | 1.22       |                                                                                               | 43,433     |                                                                                                   | $          | 1,754,160 |   |

 

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(1) Pursuant to a Plan publicly announced on August 25, 2004 and extended inJuly, 2005, in accordance with Rule 10b5-1 of the Securities Exchange Actof 1934 to provide for the repurchase of up to $2 million of the Company’scommon stock. Repurchases will be made from time to time in the open marketduring the twelve-month period ending July 31, 2006, at prevailing marketprices. Repurchases will be made under the program using the Company’s own cashresources.

 

43

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**Item 3. Defaults upon Senior Securities**

 

None

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

None

 

**Item5. Other Information**

 

None

 

**Item6. Exhibits**

 

**a.Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)              |       | Restated  Certificate of Incorporation                                                                                                                         |
|                |       |                                                                                                                                                           |
| 3.2(2)              |       | Certificate  of Designation, Preferences and Rights of Series A Preferred Stock                                                                           |
|                |       |                                                                                                                                                           |
| 3.3(3)              |       | Second  Amended and Restated Bylaws                                                                                                                            |
|                |       |                                                                                                                                                           |
| 3.4(4)              |       | Certificate  of Amendment to the Restated Certificate of Incorporation                                                                                         |
|                |       |                                                                                                                                                           |
| 4.2(5)              |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and  ComputerShare Trust Company, Inc.                                          |
|                |       |                                                                                                                                                           |
| 31.1                |       | Certification  by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 31.2                |       | Certification  by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 32.1                |       | Certification  by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                           |
| 32.2                |       | Certification  by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1)          Incorporatedby reference to the exhibit of the same number filed with the SEC with ourAnnual Report on Form 10-K for the year ended December 31, 1998.

 

(2)          Incorporatedby reference to Exhibit 2.1 to registrant’s Form 8-K filed with theSEC on June 14, 1999.

 

(3)          Incorporatedby reference to Exhibit 3.4 to registrant’s Form 8-K filed with theSEC on May 30, 2001.

 

(4)          Incorporatedby reference to Exhibit 3.4 to registrant’s Form 10-Q filed with SECon August 5, 2004.

 

44

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this Report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                          | AXT, INC. |
|-------------------------------|-----------|
|                          |      |   |
| Dated: November 8,  2005 | By:       | /s/ Philip  C. S. Yin |
|                          |      | Philip C. S.  Yin |
|                          |      | Chief  Executive Officer |
|                          |      | (Principal  Executive Officer) |
|                          |      |   |
|                          |      | /s/ Wilson  W. Cheung |
|                          |      | Wilson W.  Cheung |
|                          |      | Chief  Financial Officer |
|                          |      | (Principal  Financial and Accounting Officer) |

 

45

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(1)              |       | Restated  Certificate of Incorporation                                                                                                                         |
|                |       |                                                                                                                                                           |
| 3.2(2)              |       | Certificate  of Designation, Preferences and Rights of Series A Preferred Stock                                                                           |
|                |       |                                                                                                                                                           |
| 3.3(3)              |       | Second  Amended and Restated Bylaws                                                                                                                            |
|                |       |                                                                                                                                                           |
| 3.4(4)              |       | Certificate  of Amendment to the Restated Certificate of Incorporation                                                                                         |
|                |       |                                                                                                                                                           |
| 4.2(5)              |       | Rights  Agreement dated April 24, 2001 by and between AXT, Inc. and  ComputerShare Trust Company, Inc.                                          |
|                |       |                                                                                                                                                           |
| 10.17(6)            |       | Offer letter  to Mr. Philip C.S. Yin                                                                                                                      |
|                |       |                                                                                                                                                           |
| 10.18(7)            |       | Offer letter  to Mr. Minsheng Lin.*                                                                                                                       |
|                |       |                                                                                                                                                           |
| 10.19(8)            |       | Employment  agreement between the Company and Mr. Wilson W. Cheung.*                                                                                      |
|                |       |                                                                                                                                                           |
| 10.20(9)            |       | Agreement  respecting severance payment between the Company and Dr. Morris S.  Young.*                                                                    |
|                |       |                                                                                                                                                           |
| 31.1                |       | Certification  by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 31.2                |       | Certification  by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                     |
|                |       |                                                                                                                                                           |
| 32.1                |       | Certification  by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                                                           |
| 32.2                |       | Certification  by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1)          Incorporated by reference to the exhibit asof the same number as filed with the SEC in our Annual Report on Form 10-Kfor the year ended December 31, 1998.

 

(2)          Incorporated by reference to Exhibit 2.1to registrant’s Form 8-K filed with the SEC on June 14, 1999.

 

(3)          Incorporated by reference to Exhibit 3.4to registrant’s Form 8-K filed with the SEC on May 30, 2001.

 

(4)          Incorporated by reference to Exhibit 3.4to registrant’s Form 10-Q filed with SEC on August 5, 2004.

 

(5)          Incorporated by reference to the exhibit asof the same number as filed with the SEC in our Form 8-K on May 30,2001.

 

(6)          Incorporated by reference to Exhibit 99.1to registrant’s Form 8-K filed with the SEC on March 17, 2005

 

(7)          Incorporated by reference to Exhibit 99.1to registrant’s Form 8-K filed with the SEC on June 30, 2005.

 

(8)          Incorporated by reference to Exhibit 99.2to registrant’s Form 8-K filed with the SEC on June 30, 2005.

 

(9)          Incorporated by reference to Exhibit 99.1to registrant’s Form 8-K filed with the SEC on March 30, 2005.

 

*Management contract or compensatory plan.

 

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